Desert Trading Company has issued $100 million worth of long-term bonds at a fixed rate of 7%. The firm then enters into an interest rate swap where it pays LIBOR and receives a fixed 6% on notional principal of $100 million. What is the firm’s overall cost of funds?
LIBOR + 1%
Interest payable on bond = 7%.
Fixed interest rate receive in SWAP is 6%.
Interest rate pay in SWAP is LIBOR.
The company sold its 7% fixed rate loan for 6% in the SWAP, the effective interest rate on borrowing will be 1% above LIBOR.
Hence overall cost of funds is = LIBOR + 1%
a. Turn to Figure 17.1 and locate the contract on the Standard & Poor’s 500 Index. If the margin requirement is 10% of the futures price times the multiplier of $250, how much must you deposit with your broker to trade the September contract?
b. If the September futures price were to increase to 1,200, what percentage return would you earn on your net investment if you entered the long side of the contract at the price shown in the figure?
c. If the September futures price falls by 1%, what is the percentage gain or loss on your net investment?
The Excel Applications box in the chapter (available at www.mhhe.com/bkm ; link to Chapter 17 material) shows how to use the spot-futures parity relationship to find a “term structure of futures prices,” that is, futures prices for various maturity dates.
a. Suppose that today is January 1, 2012. Assume the interest rate is 1% per year and a stock index currently at 1,200 pays a dividend yield of 2%. Find the futures price for contract maturity dates of February 14, 2012, May 21, 2012, and November 18, 2012.
b. What happens to the term structure of futures prices if the dividend yield is lower than the risk-free rate? For example, what if the interest rate is 3%?
a. How should the parity condition (Equation 17.2) for stocks be modified for futures contracts on Treasury bonds? What should play the role of the dividend yield in that equation?
b. In an environment with an upward-sloping yield curve, should T-bond futures prices on more distant contracts be higher or lower than those on near-term contracts?
c. Confirm your intuition by examining Figure 17.1.
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