Consider the following plain vanilla interest rate swap: Volkswagen borrowed $200mm for four years with annual payments at a floating rate of one-year Libor, but now wants fixed rate liabilities. The World Bank borrowed $200mm for four years with annual payments of 6%.
1) If two entered into a plain vanilla interest rate swap with no exchange at time 0, what would the swap rate be? Use the zero coupon bond prices implied by the yield curve below (assume continuous compounding and normalize par values to $1) to discount cash flows and assume today is a reset date.
Homework Answers
| t | spot rate | discount factor |
|---|---|---|
| 1 | 0.30 % | d1 = e-0.0030 =0.9970045 |
| 2 | 1.15 % | d2 = e-0.0115x2=0.9772625 |
| 3 | 2.00 % | d3=e-.02x3=0.9417645 |
| 4 | 2.14 % | d3=e-.0214x4=0.91796134 |
Swap rate = (1 - d4) / (d1+d2+d3+d4) = 2.14 %
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