Question

problem 17: an insurance company owns $50 million of floating-rate bonds yielding libor plus 1 percent. these loans are financed with $50 million of fixed-rate guaranteed investment contracts (gics) costing 10 percent. a finance company has $50 million of auto loans with a fixed rate of 14 percent. the loans are financed with $50 million in cds at a variable rate of libor plus 4 percent. a. what is the risk exposure of the insurance company? b. what is the risk exposure of the finance company? c. what would be the cash flow goals of each company if they were to enter into a swap agreement? d. which company would be the buyer and which company would be the seller in the swap?

Answer 1

The insurance company's risk exposure is tied to changes in interest rates on floating-rate bonds. The finance company faces risk exposure due to potential losses on fixed-rate auto loans. The insurance company would aim to find a fixed-rate investment with a higher yield, while the finance company would aim to find a variable-rate investment with a lower rate. In the swap agreement, the insurance company would be the buyer of a fixed-rate investment, and the finance company would be the seller.

Step-by-step explanation:

a. The risk exposure of the insurance company is the potential loss on the floating-rate bonds if the interest rates decrease. Since the bonds are tied to LIBOR, a decrease in interest rates would result in lower yields for the company. On the other hand, if interest rates increase, the company would benefit from higher yields.

b. The risk exposure of the finance company is the potential loss on the auto loans if interest rates rise. Since the loans have a fixed rate, the finance company would not benefit from higher interest rates.

c. The cash flow goals of the insurance company would be to find a fixed-rate investment with a higher yield than their current floating-rate bonds. The finance company would aim to find a variable-rate investment with a lower rate than their current fixed-rate auto loans.

d. In a swap agreement, the insurance company would be the buyer of a fixed-rate investment, while the finance company would be the seller to exchange their fixed-rate auto loans for a variable-rate investment.