I teach the Derivative Pricing and Risk Management courses to EMBA and MBA students in Dubai and Singapore. In a recent exam, one question caused a lot of heartache and pain in exam takers. While most students understood the gist of the question, they still made a number of small mistakes that cost them valuable points in the final score.
If you have an interest rate swap pricing exam or test coming up, here is the sample question that you can use as a practice exam or practice test question. If you have detailed hands on model building interviews for your Sales & Trading, FICC or Risk Management desks, the question has a few twists that can reveal how detail oriented and hands on your candidate is.
For best results, first, try the exam and the practice and test question and then work through the solution. Do the question under exam conditions and try and attempt the practice question in one sitting.
Best of luck for your exam.
Pricing Interest Rate Swaps – Practice Exam – Test prep question
You are given the following term structure of interest rates for US$ using Yield to Maturity (YTM) of Par bonds that pay interest on a semi-annual basis
Using these Par Bond Yields please answer the following questions:
Question – Plot the following graph shown in Figure 1 using the above term structure and assuming that the coupon/interest payments happen on a Semi Annual basis. This implies that you would need to build a 10 x 10 grid at semi-annual intervals for 5 years. Your graphical plot will show projected rates at 10 points at 10 half years. (15 Points)
Question – A client has recently entered into a 4.5 year floating rate loan for US$ 400,000,000? The loan will be effective six months from now and will use the following repayment schedule. (35 points)
The client has asked for a quote for an effective interest rate risk hedge that would offset the risk of rising interest rates.
a) What would be the swap rate at cost or breakeven basis for this structure?
b) Would the client be paying fixed or receiving fixed
c) What would be the swap rate if the loan starts at time 2.5 with 10,000,000 and ends at time 3 with an outstanding principal of 10 million.
d) Six months later the interest rates term structure has changed as shown below. Taking the original Swap structure and assuming that the Swap was purchased at the original breakeven Swap rate, what is the MTM (Mark to Market value of the Swap).