An investor has purchased a floating-rate security with a 5-year maturity. The coupon formula for the floater is 6-month LIBOR plus 170 basis points and the interest payments are made semi-annually. The floater is non-callable. At the time of purchase, 6-month LIBOR is 5.5%. The investor borrowed the funds to purchase the floater by issuing a 5-year note at par value with a fixed coupon rate of 6.8%. Suppose the 5-year swap rate is 5.3% and the frequency of the payments is semi-annual. 1) Ignoring credit risk, what is the risk that this investor faces? 2) Explain how the investor can enter into a 5-year interest rate swap (in which one party pays the swap rate in exchange for 6-month LIBOR) to offset this risk and show the annual income spread the investor can lock-in using the swap contract.
An investor has purchased a floating-rate security with a 5-year maturity. The coupon formula for the floater is 6-month LIBOR plus 170 basis points and the interest payments are made semi-annually. The floater is non-callable. At the time of purchase, 6-month LIBOR is 5.5%. The investor borrowed the funds to purchase the floater by issuing a 5-year note at par value with a fixed coupon rate of 6.8%. Suppose the 5-year swap rate is 5.3% and the frequency of the payments is semi-annual.
1) Ignoring credit risk, what is the risk that this investor faces?
2) Explain how the investor can enter into a 5-year interest rate swap (in which one party pays the swap rate in exchange for 6-month LIBOR) to offset this risk and show the annual income spread the investor can lock-in using the swap contract.
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