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April 2018 Paper 1

H

Himagg

Member
Hello
Pls explain the answer to Q 4 part ii) b).
Didn't quite get it by reading the answer in the examiner's report.
Thanks in advance.
 
Hi,
The most common kind of swap is an interest rate swap, where one party with fixed interest cashflows enters a swap with another party based on a variable interest rate. If the insurance company is sensitive to interest rates and would want to immunise against changes in interest rates, it makes more sense for it to pay the fixed leg and receive the floating leg.
If future interest rate decreases, the insurance company is still paying fixed interest while receiving floating interest, which is why is perceived that the value of the swap decreases (cause it is obviously paying more!). Coupled with that, if the interest rate falls, the value of liabilities increases in terms of PV. This justifies the concept how the swap can become a liability due to a change in interest rate.
Hope this helps.
 
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