A financial institution has entered into a $10-$year currency swap with company Y$.$ Under the terms of the swap, the

financial institution receives interest at $3\%$ per annum in Swiss francs and pays interest at $8\%$ per annum in U$.$S$.$ dollars.

Interest payments are exchanged once a year. The principal amounts are $7$ million dollars and $10$ million francs. Suppose

that company $Y$ declares bankruptcy just before the exchange of year $6$ payments. The exchange rate is $$0\mathrm{.}80$ per franc.

Assume that, at the end of year $6,$ risk$-$free interest rates are $3\%$ per annum in Swiss francs and $8\%$ per annum in U$.$S$.$

dollars for all maturities.

There are two different assumptions on risk$-$free interest rate compounding frequency.

All risk$-$free interest rates are quoted with annual compounding.

All risk$-$free interest rates are quoted with continuous compounding.

The cost of default is about $$620,000.$

The difference based on the two different assumptions is about $$62,000.$

The cost of default is about $$1,200,000.$

The loss based on the annual compounding assumption is more severe than the loss based on the continuous

compounding.

The difference based on the two different assumptions is about $$1,200,000.$

The difference based on the two different assumptions is about $$620,000.$

The financial institution is in favor of defaulting on company $Y.$