Investment Interest

MODULE 6 GROUP HOMEWORK

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1. Explain the differences between a plain vanilla swap position and a Eurodollar strip.

Plain Vanilla swap is traded in an OTC market while the Eurodollar strip is considered a derivative instrument.

Plain vanilla swap is typically a floating rate note and is swapped for a fixed interest rate swap. Eurodollar strip is protective against a changing interest rate scenario

2. What is the dealer’s bid and ask quotes on a five-year swap with a quoted 60/70 swap spread over a T-note with a yield of 6.5%?

Yield on T-note Bid = 6.50% + 0.6% = 7.10%

Yield on T-note Ask = 6.50% +0.7% = 7.20%

Hence, Bid and quotes on a 5-year swap is 7.10% / 7.20%

3. The Star Chemical Company wants to finance one of its production plants by borrowing $150 million for five years. Based on its moderate credit ratings, Star can borrow five-year funds at a 10.5% fixed rate or at a floating rate equal to LIBOR + 75 bp. Given the choice of financing, Star prefers the fixed-rate loan. The Moon Development Company is also looking for five-year funding to finance its proposed $150 million office park development. Given its high credit rating, Moon can borrow the funds for 5 years at a fixed rate of 9.5% or at a floating rate equal to the LIBOR + 25 bp. Given the choice, Moon prefers a variable-rate loan. In summary, Star and Moon have the following fixed and floating rate loan alternatives:

Company	Fixed Rate	Floating Rate
Star Company	10.5%	LIBOR + 75 bp
Moon Company	9.5%	LIBOR + 25 bp

(1) Describe Moon’s absolute advantage and each company’s comparative advantage?

Particulars	Star	Moon Total
Raise Loan A	LIBOR + 75Bps	9.5%
Swaps with Counterparty B	LIBOR + 25Bps	10.5%
Net (Gain)/ Loss on Swap	50Bps	-1% -0.5% (gain)

Particulars	Total	Star	Moon
Total Gain	0.50%	25Bps	25Bps
Particulars	Star	Moon	Total
Raise Loan A	LIBOR + 75Bps	9.5%
Swap Them	LIBOR+25Bps	10.5%
(-) Gain/Loss on Swap	(25Bps)	(0.25%)
Net Cost to the Moon Company and Star Company	LIBOR (Moon)	10.25% (Star)

Star Company saves 0.25% while Moon Company only pays the LIBOR rate.

(2) What is the total possible interest rate reduction gain for the parties if both were to create synthetic positions with a swap?

25Bps

Moon 0.250%; Star 25Bps

(3) Suppose the Star and Moon companies both have the same quality ratings with the following fixed and floating rate loan alternatives. What is the total possible interest rate reduction gain for both parties if both parties were to create synthetic positions with a swap?

Company	Fixed Rate	Floating Rate
Star Company	9.50%	LIBOR + 50 bp
Moon Company	9.25%	LIBOR + 75 bp

TBD

4. Given the following:

a. The yield on a five-year, risk-free Treasury-note = 5%

b. The yield on a five-year, BB-quality bond = 8%, with the 3% spread reflecting only credit risk

c. The credit spread on a five-year CDS on the 5-year, BB-quality bond of 2%

(1) Explain how a bond investor looking for a five-year, risk-free investment could gain a 1% yield over the risk-free investment by using a CDS.

Purchase the 5-year BB rated bond paying 8%. Next, buy CDS against the BB rated bond for which the investor would pay 2% premium. The difference between 8% BB rated bond (cash inflow) and 2% CDS premium (cash outflow), they would net 6%. The 6% return is therefore 1% more than the T-note paying 5%.

(2) Explain what an arbitrageur would do.

Assuming capital needed for investment: Offer 5% = bps to an investor and give them the 5% and give them a risk-free investment. Consequently, the arbitrager will purchase the 8% paying BB-rated bond and purchase a CDS on it earning an 80 bps return on investment.

Assuming capital not needed for investment. Buy 8% paying BB rated bond, and then buy a CDS on that bond. Subsequently, short the treasury bond, and net a 1% RFR.

(3) Comment on the impact the actions by investors and arbitrageurs would have on determining the equilibrium spread on a CDS.

As the demand for BB-rated bonds surge, the bond price would rise and the yield would fall. Since bond markets rely on basic demand and supply, BB rated bond prices and the CDS spreads would meet at equilibrium of 5% where arbitrage opportunities would no longer exist. Over time, markets automatically correct themselves and the window for arbitrage opportunities closes.

Fixed-Income

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