Question

Explain why an Interest Rate Swap (assume LIBOR as the floating rate) with quarterly
settlement (assume 90 days per quarter) can be viewed as a strip of Eurodollar futures
contracts. (Note: A strip is a sequence of ED futures with successive expirations)

(b) The following table gives the bid and offer fixed rates in the swap market and the
corresponding swap rates

(i) Suppose that Company X can invest for 4 years at 4.5%. Recommend a floating
rate, can it swap this fixed rate into?

(ii) Company Y can invest for 10 years at LIBOR minus 50 basis points.
Recommend a fixed rate, can it swap this floating rate into?

Answer 1

Bid   = fixed rate in SWAP where market maker will pay fixed and receive floating;

Offer = fixed rate in SWAP where market maker will receive fixed and pay floating.

SWAP Rate = average of Bid and Offer fixed rates.

1). In this case market maker will receive fixed and pay floating then offer rate is used.

the fixed rate is 4 year offer rate = 5.39%

The difference is:

Company pays = 4.5%

Market offer rate = 5.39%

Difference = - .89%

Hence the Libor rate = Libor - .89%

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2).  In this case market maker will pay fixed and receive floating then bid rate is used.

the fixed rate is 10 year bid rate = 5.83%

= + .5%

Hence the Fixed rate = 6.33%