BANK 2006 International Currency and Banking Markets Tutorial Solutions: Topic 4 Currency Futures amp;amp; Swaps Exercises to prepare before...

BANK 2006 International Currency and Banking Markets

Tutorial Solutions: Topic 4 Currency Futures & Swaps

1. Assume the following regarding a currency futures contract:

• the spot rate and the strike rate on the futures contract are
  USD/AUD 0.7000

• each futures contract is for USD 100,000, and we have sold 7 contracts, implying that

  • we have agreed to provide USD 700,000 in four days, and

  • we will receive exactly AUD 1,000,000 in exchange at the end of the four days

• the initial deposit in the margin account is AUD 25,000, with the maintenance level being set at AUD 10,000

• the contract is for delivery in four days

• the following describes the movement of the futures price over the term of the contract

Estimate the changes in the value of the margin account consistent with the initial futures contract and your position.

If:

The AUD depreciates against the USD—that is the USD/AUD rate falls—that the value of any USD that we hold will rise, requiring the amount in the margin account to fall in order to maintain the total value of our position; and

The AUD appreciates against the USD—that is the USD/AUD rate rises—that the value of any USD that we hold will fall, requiring the amount in the margin account to rise in order to maintain the total value of our position.

Note that the above represents the margin account of a seller of the contract. The daily margin account adjustments for the buyer of the contract would be of the opposite sign, and the buyer would have ended at the finish with a margin account balance of AUD 25,715. This would have compensated the buyer for the increase in the cost of purchase of USD 700,000 over the four days.

1. You have been provided with the following information on a three-year fixed-fixed USD-GBP currency swap, the spot exchange rate between USD and GBP, and the USD and GBP yield curves:

• Notional principal–USD 5,000,000

• USD 5.5 percent coupon for GBP 6.25 percent coupon

• Spot exchange rate–GBP 1 = USD 1.45

• Current discount yield curves–USD 5.35 percent flat, GBP 6.00 percent flat.

1. 1. You wish to value the swap. What assumptions must you make to use the information that has been provided to you?

   2. Why might the swap rates differ from the discount yield curve rates used in the swap valuation?

1. 1. What is the time zero value of the swap to the USD receiver?

1. 1. What settlement payment will ensure fair value against the swap to both parties, and to whom must it be paid?

1. 1. What is the implied exchange rate between USD and GBP for the interest payments made under the swap? Should you expect this rate to match the current value of the exchange rate? Explain.

This rate need not match current exchange rates due to the term of the contract, interest differentials between countries (i.e. differences in the level and shape of the yield curve), and differences in credit rating between parties.

1. You have borrowed USD 3,000,000 of four-year funds against annual USD cash flows expected from a project in the north of America. As these funds were borrowed at a variable interest rate and you required some certainty over the size of payment cash flows, you have used a four-year USD interest rate swap to fix payments. Recently, you have been told that the investment project is to move to Canada, with the result that the cash flows from the project will occur in CAD. One alternative available to you is to use a combination of swaps to transfer the fixed stream of CAD cash flows to USD fixed cash flows. You have the following information on the swap, foreign exchange and government bond markets:

• The spot FX rate is CAD 1.2255 = USD 1.

• Your current 4-year USD interest-rate swap rate is set at 0.15% above the USD yield curve rate for maturity equal to that of the swap.

• Your bank will quote a CAD cross-currency swap rate if you require this information.

• Current discount yield curves are flat for both the USD and CAD at USD 5.35% and CAD 7.05%.

You may assume that your credit rating and swap spread will remain constant over the life of the swap contracts, and that you face no bid-ask spread.

1. 1. How could you structure a pair of swaps between CAD and USD so as to get a fixed-fixed swap outcome where your CAD cash inflows are converted to fixed USD cash flows? Show this financial structure by using appropriately drawn diagrams.

1. 1. What fixed rate on the CAD cross-currency swap will ensure that the structured fixed-fixed swap has fair value at inception of the contract?