Report on Mdp Swap

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MONTE CARLO SIMULATION

Q1

Mdp firstly swapped it floating-rate debt to 4.76% fixed rate. It was advised by government auditors to reduce the rate in 2005. As a result, MdP entered into a second swap in 2007 to swap the interest payments into much lower interest payments currently.

Q2

MdP Company received 3% fixed rate from Santander, and paid Santander zero spread during the first 2 years of the swap. It means that MdP reduced its interest payment by 3% a year.

Q3

Since MdP entered into the swap, Santander paid 3% fixed interest payments every year. MdP firstly paid nothing in the first 2 years, and then the spread payable occurred. When the Euribor rate deviated from the range of 2%-6%, the spread payable snowballed quarterly.

For the bank Santander it was likely to buy insurance by paying 3% a year to hide the risk due to the abnormal volatility. However, for Mdp it was likely to do a risky leveraged trade due to the spread snowballed.

Q4

In this case, 3-month Euribor interest rate is forecasted by Cox-Ingersoll-Ross model. The key features are described as follow.

In the equation 1, the ‘a(b-rt) dt’ term represents that interest rate has an expected drift rate of ‘a(b-rt)’ per unit time. In the particular term, ‘b’ shows the long-run mean of the interest rate. The model allows the interest rate to approach to it. If current rate is above the mean rate, it expected to decrease to the mean rate. The ‘a’ refers to the speed of the mean reversion.

The sigma represents the volatility of the interest rate. Both the drift and the volatility are depended on the level of the interest rate.

Q5

The interest rate under the CIR model should be non-negative value. Using the equation 2, the fatal flaw is that it does not avoid the possibility of negative interest rate. The interest rate should be maximum of zero and rt.

Q6