Twin Oaks Brewery (TOB) needs to borrow $20 million immediately. It can borrow for three years at a fixed rate of 7.5% or at a floating rate of LIBOR + 40 basis points. Plain vanilla fixed-for-floating three-year swaps are priced at 7.3% fixed, in exchange for floating LIBOR. If TOB believes that interest rates are about to rise sharply, what should it do? If TOB believes that interest rates are about to decline sharply, what should it do?
A portfolio manager wants to mitigate the downside risk of her $36 million portfolio in semiconductor stocks. The manager has a long-term bullish outlook on the banking sector, but fears that the sector may suffer a short-term correction next year. The fund manager estimates that the portfolio return is highly correlated with the PHLX Semiconductor Sector Index (SOX)
She enters an equity swap with a 12-month tenor:
She agrees to receive a fixed payment of 7.2% and pay the swap dealer the capital gain on the PHLX Semiconductor Sector Index
Payments are made quarterly and the notional principal is set at $36 million
Assume the quarterly returns on SOX are -2.5%, -3.25%, 5.75%, and 4.2%
Further assume the actual returns of her portfolio exactly equal the KBW Bank Index
Please calculate the cash flow received and paid by the portfolio manager to the swap dealer.
(Similar to Lecture Notes on Swaps, Slide #35-36)