Question
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
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 4% 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 8 million dollars and 12 million francs. Suppose that company Y declares bankruptcy at the end of year 6, when the exchange rate is $0.75 per Swiss franc. What is the cost to the financial institution? Assume that, at the end of year 6, the risk-free interest rate is 3% per annum in Swiss francs and 8% per annum in U.S. dollars for all maturities. All interest rates are quoted with annual compounding.
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