Explanation:
The current exposure of a swap is the present value of the remaining cash flows if its value is positive to the bank. The bank receives fixed 8% and pays floating. After one year, the prevailing market swap rate declines by 150 basis points to 6.5%. Because the bank receives a higher fixed rate than the current market, the swap has positive value. The positive difference in fixed payments per year over the remaining 4 years is: (8.0% - 6.5%) × GBP 200 million = 1.5% × GBP 200 million = GBP 3 million. The present value of a 4-year annuity of GBP 3 million at a 6.5% discount rate is: PV = GBP 3 million × [1 - 1 / (1 + 0.065)^4] / 0.065 = GBP 3 million × 3.4258 = GBP 10.2774 million. This is closest to GBP 10.28 million.
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Q.63 Prime Bank enters into a GBP 200 million, five-year annual-pay interest rate swap. According to contractual specifications, the bank receives 8% fixed against 12-month LIBOR. Suppose the swap rate declines by 150 basis points over the first year. The current exposure at the end of year one is closest to:
A
GBP 5.10 million
B
GBP 10.825 million
C
GBP 10.28 million
D
GBP 5.1387 million
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