Suppose under the terms of a swap AMR Corp. agreed to pay a fixed rate of interest and receive a variable rate of interest based on LIBOR. Payments are every six months and the swap has a remaining life of 14 months (i.e., there are three remaining payments with the next payment in 2 months). The fixed interest rate is 7% per year with semiannual compounding and the notional principal of the swap is $20 million. The LIBOR rate at the last payment date (4 months ago) was 6.5% per year with semiannual compounding.
The LIBOR rate appropriate for discounting cash flows in 2 months is 7% per year with monthly compounding. The LIBOR rates appropriate for discounting cash flows in 8 and 14 months are 7.5% and 8% per year with semiannual compounding.
Answer the following questions.
A. Compute the equivalent annual LIBOR rates (i.e., LIBOR rates with annual compounding) appropriate for discounting cash flows in 2, 8, and 14 months.
B. Using your equivalent annual LIBOR rates in part A, compute the forward rates for the two six-month periods starting 2 and 8 months from today.
C. Convert the two forward LIBOR rates computed in part B from annual compounding to semiannual compounding.
D. Use the bond valuation approach to compute the value of AMR’s swap.
E. Use the FRA approach to compute the value of AMR’s swap.