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Double-cancellable swaps Recall that K{10nc x Berm ann} is the fixed rate such that a swap, where we pay fixed for ten years with the right to cancel after x years and annually thereafter, has zero value. Suppose you observe the following rates.• K{10nc1 Berm ann} 7.20%.• K{10nc2 Berm ann} 7.10%.• One-year swap rate 6.10%.• Two-year swap rate 6.15%. Ten-year swap rate 7.00%.
(a) Bank A wants to pay fixed on a {10nc1 Berm ann} swap to Bank B. However, suppose in addition that Bank B itself has the European option to cancel this swap after one year. Determine the most likely rate for this ‘double-cancellable' swap from the following.• I > 7.20%• II 7.20%• III > 6.10% but• IV 6.10%
(b) Bank A wants to pay fixed on a {10nc2 Berm ann} swap to Bank B, and once again Bank B has the European option to cancel the swap after one year. Determine the most likely rate for this ‘double-cancellable' swap from the following.• I > 7.10%• II 7.10%• III > 6.15% but• IV 6.15%
Calculate the present value break-even point (also called the financial break-even point). Initial Investment: $700. Fixed Cost: $200 per year
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