Interest rate swaps Phillip$$s Screwdriver Company has borrowed $$20$ million from a bank at a floating interest rate of $2$ percentage points above three$-$month Treasury bills, which now yield $5\%.$ Assume that interest payments are made quarterly and that the entire principal of the loan is repaid after five years.

Phillip$$s wants to convert the bank loan to fixed$-$rate debt. It could have issued a fixed$-$rate five$-$year note at a yield to maturity of $9\%.$ Such a note would now trade at par. The five$-$year Treasury note$$s yield to maturity is $7\%.$

Is Phillip$$s stupid to want long$-$term debt at an interest rate of $9\%?$ It is borrowing from the bank at $7\%.$

Explain how the conversion could be carried out by an interest rate swap. What will be the initial terms of the swap? $($Ignore transaction costs and the swap dealer$$s profit.$)$

One year from now short and medium$-$term Treasury yields decrease to $6\%,$ so the term structure then is flat. $($The changes actually occur in month $5.)$ Phillip$$s credit standing is unchanged; it can still borrow at $2$ percentage points over Treasury rates.

What net swap payment will Phillip$$s make or receive?

Suppose that Phillip$$s now wants to cancel the swap. How much would it need to pay the swap dealer? Or would the dealer pay Phillip$$s$?$ Explain.

Currency hedging Alpha and Omega are U$.$S$.$ corporations. Alpha has a plant in Hamburg that imports components from the United States, assembles them, and then sells the finished product in Germany. Omega is at the opposite extreme. It also has a plant in Hamburg, but it buys its raw material in Germany and exports its output back to the United States. How is each firm likely to be affected by a fall in the value of the euro? How could each firm hedge itself against exchange risk?

Currency risk Suppose that in $2023$ one$-$ and two$-$year interest rates are $5\mathrm{.}2\%$ in the United States and $1\mathrm{.}0\%$ in Japan. The spot exchange rate is $120\mathrm{.}22/$$$.$ Suppose that one year later interest rates are $3\%$ in both countries, while the value of the yen has appreciated to $115\mathrm{.}00/$$$.$

Benjamin Pinkerton from New York invested in a U$.$S$.$ two$-$year zero$-$coupon bond at the start of the period and sold it after one year. What was his return?

Madame Butterfly from Osaka bought some dollars. She also invested in the two$-$year U$.$S$.$ zero$-$coupon bond and sold it after one year. What was her return in yen?

Suppose that Ms$.$ Butterfly had correctly forecasted the price at which she sold her bond and that she hedged her investment against currency risk. How could she have hedged? What would have been her return in yen?