Interest Rate Risk and Swaps (10 points)

a) How does organized exchange trading in swaps remove any risk that the counterparty in a swap agreement will not complete the agreement?

b) Choose 3 correct answers from the following problems, consider these debt strategies being considered by a corporate borrower. Each is intended to provide 1,000,000 in financing for a three-year period

Strategy#1: Borrow 1,000,000 for three years at a fixed rate of interest of 7%

Strategy#2 Borrow 1,000,000 for three years at a floating rate of LIBOR +2%, to reset annually. the current LIBOR rate is 3,5%

Strategy#3: Borrow 1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%

Problem 3. b1. Choosing strategy #1 will (1p)

a) guarantee the lowest average annual rate over the next three years

b) eliminate credit risk but retain repricing risk

c) maintain the possibility of lower interest rates, but maximizes the combined credit and repricing risk

d) preclude the possibility of sharing in lower interest rates over the three-year period.

Problem 3. b2. Choosing strategy #2 will (1p)

a) guarantee the lowest average annual rate over the next three years

b) eliminate credit risk but retain repricing risk

c) maintain the possibility of lower interest rates, but maximizes the combined credit and repricing risk

d) preclude the possibility of sharing in lower interest rates over the three-year period.

Problem 3. b3. Choosing strategy #3 will (1p)

a) guarantee the lowest average annual rate over the next three years

b) eliminate credit risk but retain repricing risk

c) maintain the possibility of lower interest rates, but maximizes the combined credit and repricing risk

d) preclude the possibility of sharing in lower interest rates over the three-year period.