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    A. Option A
    B. Option C
    C. Option B
    D. Option D
    Answer: D

    NEW QUESTION: 2
    An investor enters into a 4 year interest rate swap with a bank, agreeing to pay a fixed rate of 4% on a notional of $100m in return for receiving LIBOR. What is the value of the swap to the investor two years hence, immediately after the net interest payments are exchanged? Assume the current zero coupon bond yields for 1,
    2 and 3 years are 5%, 6% and 7% respectively. Also assume that the yield curve stays the same after two years (ie, at the end of year two, the rates for the following three years are 5%, 6%, and 7% respectively).
    A. -$2,749,326
    B. $3,630,846
    C. - $3,630,846
    D. $2,749,326
    Answer: B
    Explanation:
    Explanation
    The swap can be valued by valuing the two individual components of the swap.
    The fixed rate bond equivalent in the swap is valued at =4/1.05 + 104/(1.06

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    2) = $96,369,154.
    The FRN component will be valued at par as we are at a point where the rate has just been reset, ie $100m.
    The investor is paying the fixed rate, and is therefore short the bond. He/she is receiving LIBOR, and is therefore long the FRN. The value of the swap to the investor therefore is +$100,000,000-$96,369,154 =
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    Detailed explanation:
    An Interest Rate Swap exchanges fixed interest flows for floating rate flows. The floating rate leg is tied to some reference rate, such as LIBOR. The parties exchange net cash flows periodically. Conceptually, an interest rate swap is the combination of a fixed coupon bond and a floating rate note. The party receiving the fixed rate is long the fixed coupon bond and short the FRN, and the party receiving the floating rate is long the FRN and short the fixed coupon bond.
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    There are two ways to value a swap. If interest rates for the future are known, the bond and the FRN can be valued and their difference will be equal to the value of the swap. Sometimes, the current swap rates are known. In such a case, the swap can be valued by imagining entering into an opposite swap at the new swap rate, which will leave a residual fixed cash flow for the remaining life of the swap. This residual cash flow can be valued and that represents the value of the swap. For example, if a 4 year swap was entered into exchanging an annual fixed 5% payment on a notional of $100m for a floating payment equal to LIBOR, and at the end of year 1 the swap rate is 6%, then the party paying fixed can choose to enter into a new swap to receive 6% and pay LIBOR. All cash flows between the old and the new swap will offset each other except a net receipt of 1% for the next 3 years. This cash flow can be valued using the current yield curve and represents the value of the swap.

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