Q1 : Company CCC3, a low-rated firm, desires a floating-rate, long-term loan. CCC3 presently has access to floating interest rate funds at a margin of 6.5% over LIBOR. Its direct borrowing cost is 14% in the fixed-rate bond market. In contrast, company AAA1, which prefers a fixed-rate loan, has access to fixed-rate funds in the Eurodollar bond market at 12% and floating-rate funds at LIBOR + 3.5%. A financial institution has brought these two firms together and facilitated the swap by taking the counterparty risk and requires a net total compensation package of 0.4% (this does not mean 0.4% from each, it means 0.4% total).

a)What is the size of the mispricing (if any)?

(b)Design a swap acceptable to both companies and the financial institution. Split the benefits evenly between the two companies. Diagram the cash flows of the two companies and the financial institution. Clearly indicate the swap rates that the two companies and the institution are using.

c) What is the final borrowing rate for each company?

Q2: A U.S. firm is receiving 185m JPY in 3 months' time. JPY Futures are available on the Chicago Mercantile Exchange (CME) with a contract size of 12,500,000 JPY and currently trade at 0.009502 JPY/USD. The contract maintenance margin is 3600 USD with an initial margin of 110% of the maintenance margin.

a) Describe the firm's FX spot market currency exposure (long/short, size of exposure) before hedging.

b)Describe how this firm would hedge its position using futures contracts.

c)How many contract positions on the CME should be taken if the goal is to minimise the firm's exposure to risk?

d)What will be the initial futures cash flow required (amount and currency)?

e)Assuming that the exposure and contract maturity dates are the same, what is the expected

total (Physical + Hedge) net USD cashflow? (You may ignore the time value of money and you may assume that the Unbiased Expectations Hypothesis holds)