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FRA and SWAPS
FRA and SWAPS
Solution:
The market conditions are summarized as follows:
I$ = 4%; i = 3.5%; S = 1.01/$; F = 0.99/$.
If $100,000,000 is invested in the U.S., the maturity value in
six months will be $104,000,000 = $100,000,000 (1 + .04).
Alternatively, $100,000,000 can be converted into euros and
invested at the German interest rate, with the euro
maturity value sold forward.
In this case the dollar maturity value will be $105,590,909 =
($100,000,000 x 1.01)(1 + .035)(1/0.99)
Clearly, it is better to invest $100,000,000 in Germany with
exchange risk hedging.
S = $1.5/; F = $1.52/;
I$ = 2.0%; I = 1.45%
Credit = $1,500,000 or 1,000,000.
a. (1+I$) = 1.02
(1+I)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
Since (1+I$) = 1.02 is cheaper, borrow USD directly.
b. (1) Borrow $1,500,000; repayment will be
$1,530,000.
(2) Buy 1,000,000 spot using $1,500,000.
(3) Invest 1,000,000 at the pound interest rate of
1.45%; maturity value will be 1,014,500.
(4) Sell 1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
Borrow $1,000,000 for six months at 3.5% per year. Need to pay
back $1,000,000 (1 + 0.0175) = $1,017,500 six months
later.
Convert $1,000,000 to SFr at the spot rate to get SFr 1,662,700.
Lend SFr 1,662,700 for six months at 3% per year. Will get back
SFr 1,662,700 (1 + 0.0150) = SFr 1,687,641 six months later.
Sell SFr 1,687,641 six months forward. The transaction will be
contracted as of the current date but delivery and settlement
will only take place six months later.
So, six months later,
exchange SFr 1,687,641 for SFr 1,687,641/SFr 1.6558/$ =
$1,019,230.
The arbitrage profit six months later is 1,019,230 1,017,500 =
$1,730.
Fixed
Floating
X 11.5 P+2.00
Y 9.75 P+.5
Diff 1.75 1.5
Diff = 25 bp, split as 5 bp to bank, 10
to each X/Y
X effective 11.4; bank pays P+2
Y effectiveP+.4; bank pays Y 9.75%;
Dollar
Pound
Dell
Virgin
8.5
QSD is 1.5 : here, no firm has absolute advantage; both have only relative
advantage
Virgin would borrow 10 million for two years and Dell would borrow $16
million for two years. The two companies would then swap their proceeds
and payment streams.
Assuming no interest rate adjustments, Dell would pay 8.5% on the 10
million and Virgin would pay 7% on its $16 million. Given that its alternative
was to borrow pounds at 9%, Dell would save 0.5% on its borrowings, or an
annual savings of 50,000. Similarly, Virgin winds up paying an interest rate
of 7% instead of 8% on its dollar borrowings, saving it 1% or $160,000
annually.
Dell
Virgin
Dollar
Pound
Dell
Virgin
8.75
9.5
Fixed yen
FRN dollar
KDB
4.9
L+0.8
IBM
4.5
L+0.25
Difference
0.4
0.55
LIBOR +
0.5%
LIBOR + 1.0%
5%
6.50%
Principal
amount ($)
Rate
US
9%
$100,00,000
8%
Japan
4%
12000,00,000
5%
Time
CF on dollar
bonds
PV ($)
CF on Yen bond
(yen)
Exchange rate =
PV (yen)
$8,00,000
$7,31,144.95
600,00,000
576,47,366.35
$8,00,000
$6,68,216.17
600,00,000
553,86,980.78
$108,00,000
$82,44,498.54
12600,00,000
11175,19,750.26
Total
$96,43,859.66
Value of swap =
$15,42,995.77
12305,54,097.40
110 yen/dollar
Equity investment
Suppose you are a euro-based investor who just
sold Microsoft shares that you had bought six
months ago. You had invested 10,000 euros to
buy Microsoft shares for $120 per share; the
exchange rate was $1.15 per euro. You sold the
stock for $135 per share and converted the dollar
proceeds into euro at the exchange rate of $1.06
per euro. First, determine the profit from this
investment in euro terms. Second, compute the
rate of return on your investment in euro terms.
How much of the return is due to the exchange
rate movement?
FRA
A bank sells a three against six $3,000,000 FRA for a
three-month period beginning three months from
today and ending six months from today. The purpose
of the FRA is to cover the interest rate risk caused by
the maturity mismatch from having made a threemonth Eurodollar loan and having accepted a sixmonth Eurodollar deposit. The agreement rate with
the buyer is 5.5 percent. There are actually 92 days in
the three-month FRA period. Assume that three
months from today the settlement rate is 0.4875
percent. Determine how much the FRA is worth and
who pays who--the buyer pays the seller or the seller
pays the buyer.
FRA
Since the settlement rate is less than
the agreement rate, the buyer pays
the seller the absolute value of the
FRA. The absolute value of the FRA
is:
$3,000,000 x [(.04875-.055) x
92/360] /
[1 + (.04875 x 92/360)]
= $3,000,000 x [-.001597/(1.012458)]
= $4,732.05.
Bonds and FX
Consider 8.5 percent Swiss franc/U.S.
dollar dual-currency bonds that pay
$666.67 at maturity per SF1,000 of par
value. What is the implicit SF/$ exchange
rate at maturity? Will the investor be
better or worse off at maturity if the
actual SF/$ exchange rate is
SF1.35/$1.00?
Implicit exchange rate : SF1.5, worse off if
SF 1.35/USD