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3. (9 points)

Suppose a life insurance company issued $100 million of five-year contracts (a loan) that commit it to pay a fixed rate of 9% annually. Suppose the company is able to invest $100 million in a five-year floating rate instrument yielding LIBOR plus 100 b.p. (basis points, 100 b.p. = 1%).

3.1 Describe the interest exposure by the insurance company. At what point would the company not be able to earn enough on the floating rate instrument to pay for its fixed obligations? (Hint: the LIBOR rate at which the company is not able to earn enough to pay for its fixed obligations) (3 points)

3.2 Suppose there is available in the market a 5-year fixed-floating interest rate swap with a notional amount of $100-million, with which the swap dealer agrees to pay (or receive) LIBOR for fixed 8.5%. How can the insurance company use this swap to hedge its interest rate exposure? Choose from the following arrangements: (3 points)

A: The insurance company pay fixed 8.5% to and receive LIBOR from the dealer.

B: The insurance company pay LIBOR to and receive fixed 8.5% from the dealer.

3.3 Calculate the spread the company would lock in if it chooses to enter the swap agreement. (3 points)