CFA Practice Question

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CFA Practice Question

Assume that you are analyzing a plain vanilla interest rate swap with the following characteristics:

Counterparty X : Counterparty Y
pay fixed rate 6% : pay floating rate LIBOR + 0.5%
receive floating rate LIBOR + 0.5% : receive fixed rate 6%
Swap tenor: 10 years
Notional principal: $1,000,000
LIBOR0: 4.75%

If this were an "in-advance" swap, Counterparty X would make its first fixed rate payment at the time the swap is negotiated. The amount of the payment would be ______.
A. $60,000
B. $52,500
C. $57,279.24
Explanation: In this case, the first payment would be the present value of the "in arrears" amount, discounted at LIBOR. (1,000,000)(.06)/(1.0475)1 = 57,279.24

User Contributed Comments 19

User Comment
Yuyan Counterparty Y will pay: =(1,000,000)*(0.0475)/(1.0475)=45,346.06
Yuyan The same, it should be discounted at LIBOR (marketwide convention for in-advance swap). But actual payent would be only the net payments.
Yuyan Correction: Couterparty Y will pay: =(1,000,000)*(0.0475+0.005)/(1.0475)=50,119.33
shasha hey, Yuyan, afraid you have to make a correction again for PV of 1st year payment from Y to X = (1,000,000)*(.0475+.005)/(1.0475+.005), i mean, i don't know "market convention", however, i believe i know the calculation for PV.
shasha well, Yuyan, forgot to say, my meaning is: you're right, simply with my belief the "market convention" of discounting at LIBOR makes too little room of flexibility.
geet Why are we discounting back? Why isnt it just 60000?
akurt Because the first payment is normally paid (in this case) one year out. Since you are receiving the payment now instead of later, you will discount for time value of money which is LIBOR (not LIBOR + 0.005, because the 0.005 is the premium that Y must make, not included in the PV)
KD101 Essentially we are discouting fixed payment using LIBOR as a discount rate
cb0079 In a plain vanilla currency swap, only the netted payments are made. Hence all answers (A-D) are wrong.
leachim Well, i am a swap trader for 2 years now, but if i have to pay 6% when it is negotiated (=spot) i will not discount anything !!
yanpz I still don't get why we have to discount it using LIBOR... but I also believe payment should be netting X to Y and Y to X.
Shelton X: 1000000 * 6% / (1+4.75%) = 57279
Y: 1000000 * (4.75%+0.05%) / (1+4.75%+0.05%) = 49881
group posted sudhir(1,000,000)(.06)/(1.0475)1 = 57,279.24
shiva5555 The LOS says the payments should be netted. Guess they only want you to look at one side though here.
Sibong26 I don't understand why it is discounted by LIBOR???
dan1987 The question states "If this were an "in-advance" swap" and is only in reference to Counter Party X.

Meaning that "X" has to pay "in advance" rather than at the end of each period.

Therefore since this is 1 period sooner than usual there is a time value of money issue. So the 60k needs to be discounted back by 1 periods interest rate and this case it is LIBOR.
Shaan23 If I just read the text books and hit the exam....doomed....I didnt have to read the texts....should've just did questions...
Shaan23 People should Company Y's calculation on here as well. Why are people discouting at 5.25% and not Libor which is 4.75%?

We discounted X by 4.75% and I'm assuming you must do the same for Y--- thats the market rate.
jjhigdon Agree with Shaan23. You discount using LIBOR. The discount rate is supposed to represent an market based opportunity cost, for which the +50bps specified in this particular swap is not a factor.
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