Question 3 April 2008 - swap on property

[abumenang]

Hi there,

In this question, how would you know the cashflows received.

Would you just assume that the net result is the life office receiving fixed payments?

Also, in part (i), the acted solutions says that the fixed payments would be set at a level that the npv of swap is zero at outset.

Then part (ii) says the swap results in higher payments to the life company in the early years. This seems contradictory to (i). Please can you explain why this is so?

The question says that this would be a separate contract to the lease & subject to daily collateralisation - how does this relate to the answer?

Thanks.

 

[Colin McKee]

property question

Hi, In answer to you questions, I think the first question is the easiest, because the examiner says "exchange the inflation linked payments for fixed payment". So the swap described is definitely a "rents for fixed" rather than a "rents for floating" which was also a possibility.
The second and third questions are trickier. You are right that the PV of the swap would be set to zero at the outset. But if rents rise with inflation over the term, the rents will be higher at the end of the period than at the start. Since the flip side of the swap is a series of fixed payments, it stands to reason that the rents will be less than the fixed at the start, and more than the fixed payments at the end of the swap.
And finally the collateral - I am not sure exactly how this impacts the question. Perhaps its because the later part asks for "risks". If there was no collateral, there would be a lot of risks popping into the question. Whereas with collateral, some of the obvious risks are reduced, and we need to think harder about other risks such as void etc. So maybe its what it rules out rather than adds in. Hope this helps.