5. Assume that a bank enters into a USD 100 million, 4-year annual pay interest rate swap, where the bank receives 6% fixed against 12-month LIBOR. Which of the following numbers best approximates the current exposure at the end of year 1 if the swap rate declines 125 basis points over the year?

A. USD 3,420,069

B. USD 4,458,300

C. USD 3,341,265

D. USD 4,331,382

Correct answer is A

If the swap rate declines 125 basis points to 4.75%, the value of the receive-fixed swap increases (i.e. positive) by an amount equal to the present value of a $1,250,000 (1.25% X $100 million) annuity for three years (4 years ? 1 year) at 4.75%. Using financial calculator, Pmt = 1,250,000; N = 3; I/Y = 4.75 -> Compute PV = $3,420,069

B to D: Incorrect answers because of using either incorrect discount factors or incorrect period discounted.

Reference: John B. Caouette, Edward I. Altman, and Paul Narayanan, Chapter 21.

Type: Credit Risk.