Question
Interest Swap Problem Assume that AAA can borrow $s at 5% or can borrow s at 8%. BBB can borrow $s at 7% or can
Interest Swap Problem
Assume that AAA can borrow $s at 5% or can borrow s at 8%. BBB can borrow $s at 7% or can borrow s at 9%. The risk-free rates in $s and s are 4.5% and 7% respectively. AAA want to borrow 10M and BBB want to borrow $16M. Current exchange rate is 1.6$/. In case of the swap, the swap bank demands half of the QSD and the rest of the QSD is divided equally between AAA and BBB.
a)What will be the swap bank's profit next year if next year exchange rate will be 1.58?
Professor's Solution: Profit= 16*(0.0675-0.05)+1.58*10*(0.0775-0.09)=$82,500
b)Assume that the swap bank hedges its exchange rate risk with forward contracts. Find its profit next year (in dollars)?
Professor's Solution: E(S)=F=1.6*1.045/1.07=1.5626 - Hence, profit= 16*(0.0675-0.05)+1.5626*10*(0.0775-0.09)=$84,675
Specific Requests:
1) I would like a full explanation of the rationale/process behind the solutions provided (I cannot tell where some of the numbers are coming from). Preferably, I would like some form of diagram to follow along with as well.
2) My professor said that on the exam, she will not explicitly tell us the breakdown of the QSD - so she would remove the following part of the question: "In case of the swap, the swap bank demands half of the QSD and the rest of the QSD is divided equally between AAA and BBB". Instead, she will ask us to come up with a possible QSD agreement on our own (we would offer a possible strategy that would benefit all parties). I would like to know how I would go about doing this.
Let me know if any clarification is required.
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