Question 1 (a) Companies X and Y have been offered the following rates per annum on a $5 million 10-year investment: Fixed (p.a.) Company X Company Y 8.0% 8.8% Floating (p.a.) LIBOR LIBOR Note: p.a. abbreviates for per annum, and LIBOR stands for the London Interbank Offered Rate". Required: Company X requires a fixed-rate investment; company Y requires a floating-rate investment. Design a swap that will net a bank, acting as intermediary, 0.2% per annum and will appear equally attractive to X and Y. Assume floating rate payments/receipts are made based on LIBOR rates. Use the following diagram to express your answers. Company X Bank Company Y (8 marks) (b) 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 at the end of year 6 just before the exchange of payment, when the exchange rate is $0.80 per franc. Assume that, at the end of year 6, the risk-free interest rate is 3% per annum in Swiss francs and 8% per annum in U.S. dollars for all maturities. All interest rates are quoted with annual compounding. Assume that the theoretical forward exchange rates can be realized. Also assume there are 360 days in a year. Required: What is the cost to the financial institution in U.S. dollars? You may want to keep your answers to 2 dps. Rounding errors will not be penalized. Hint: You may use the following table to guide your calculations. Dollar paid Year CHF received Forward Exchange rate Dollar equiv. of CHF received Net Cash Flow ($) PV of Cash Flow PV Factor lost ($) 0 1 2 3 4