Company plans to take out a $10 million floating-rate loan in two years. The loan will be for five years with annual payments at the rate of LIBOR. The company
anticipates using a swap to convert the loan into a fixed-rate loan. It would like to
purchase a swaption to give it the flexibility to enter into the swap at an attractive
rate. The company can use a payer or a receiver swaption. Assume that the exercise
rate would be 6.5 percent.
A. Identify what type of swaption would achieve this goal and whether the company
should buy or sell the swaption.
B. Calculate the company”s annual cash flows beginning two years from now for
two cases: The fixed rate on a swap two years from now to terminate five years
later, FS(2,7), is 1) greater or 2) not greater than the exercise rate. Assume the
company takes out the $10 million floating-rate loan as planned.
C. Suppose that when the company takes out the loan, it has changed its mind and
prefers a floating-rate loan. Now assume that the swaption expires in-the-money.
What would the company do, given that it now no longer wants to convert to a
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