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To further diversify across asset classes, Midland Pensions is considering investing in fixed income securities specially UK treasury bonds (with quarterly interest payments). In order to manage the risk of this proposed investment, Midland is interested in learning more about derivative contracts particularly swaps for risk management. Your line manager requires your report to cover the pricing and valuation of swaps.
Required:
Question 1: Recommend the appropriate type of swap contract for Midland Pensions based on the information available. Justify your recommendation.
Question 2: Illustrate the pricing of a hypothetical swap contract that you recommended in 1 above; assume an investment of £5,000,000, payments made quarterly for one year. For any missing Libor term rates, assume that the term structure of interest rates is linear and upward sloping. Provide detail descriptions of each step.
Question 3: Illustrate the value of the same swap contract in B, after 2 month has lapsed. Provide details of your assumptions with justification (explanation) of each.
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