Answer to Question #159387 in Economics for Ayesha

Question

Suppose you are working as a treasurer in Citibank and your bank has taken a PKR250 million loan. The interest on the loan is KIBOR+50bp paid semiannually. The duration of the loan is four years. As you will have to pay interest, you are worried that in the future interest rates are likely to increase and you want to hedge this position by entering into a Swap contract. You ask Bank Al-Habib whether they would be willing to enter into a swap agreement and they send you these semi-annual swap rates:

Consider the following questions:

What will the swap structure look like, given the fact that a bank Al-Habib requires an additional 5bp credit risk return for this client? Draw a diagram (4 marks)

What is the company’s cost of funds?

Answer 1

A swap is a derivative financial instrument, a contract under which an asset is sold and at the same time an obligation is assumed to repurchase it back at a fixed price. A swap can be used for financing secured by securities and, conversely, for borrowing securities for the purpose of delivering them under a contract, for example, in the case of opening a short position. Such transactions are called repo transactions. In addition, the swap serves to change the composition of the foreign exchange portfolio, when the required currency is borrowed for a certain period against the security of another currency.

The most common today is swap contracts in the interbank market - for interest rates when payments are exchanged at floating and fixed interest rates.

Swap trades are over-the-counter. That is, contracts are not standardized. Terms and volumes can be any as agreed by the parties. Accordingly, there can be an infinite variety of such operations.