1) Canuck Oil is also exposed to interest rate risk, as it has issued 2,000 fixed rate coupon bonds with a face value of $1,000 each. The current interest rate on similar coupon bonds is 8%. The company can also borrow at a rate of prime + 2%. Mr. Rich believes that the interest rate will fall in the future, and would like to see if the company can switch to a flexible interest rate on its debt. Describe how the company and its investment dealer can design a plain vanilla swap with a counterparty who can borrow at a fixed rate of 10% or a flexible rate of prime + 1%. The investment dealer generally makes a spread of 1% on this type of swap. Use a diagram to illustrate this swap transaction.
Canuck Oil Corporation is a Canadian crude oil producer. Today is July 15. Canuck’s estimated oil production level in three months’ time will be 100,000 barrels. The current spot price for crude oil is US$90.29 per barrel. Between January 15 and now, crude oil prices have fluctuated from a high of $110.82 to a low of $90.56.
Due to the unstable nature of crude oil prices, Canuck Oil’s
|
Delivery month |
Last |
Change |
Prior settlement |
Open |
High |
Low |
Volume |
|
September |
90.79 |
–0.58 |
91.37 |
91.24 |
91.44 |
89.76 |
9067 |
|
October |
92.18 |
–0.48 |
92.66 |
92.89 |
95.22 |
89.30 |
5229 |
|
November |
90.13 |
–0.35 |
90.48 |
90.22 |
90.55 |
89.08 |
1685 |
- Contract size: 1,000 barrels
- Contract currency: US dollar
- September expiry: September 16
- October expiry: October 16
- November expiry: November 16
1) Canuck Oil is also exposed to interest rate risk, as it has issued 2,000 fixed rate coupon bonds with a face value of $1,000 each. The current interest rate on similar coupon bonds is 8%. The company can also borrow at a rate of prime + 2%. Mr. Rich believes that the interest rate will fall in the future, and would like to see if the company can switch to a flexible interest rate on its debt. Describe how the company and its investment dealer can design a plain vanilla swap with a counterparty who can borrow at a fixed rate of 10% or a flexible rate of prime + 1%. The investment dealer generally makes a spread of 1% on this type of swap. Use a diagram to illustrate this swap transaction.
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