Question 2 - Swaps (a) Using your own hypothetical examples, critically evaluate any two reasons why investors may use plain vanilla currency swaps. Write out and explain the swaps you have designed. (8 marks) (b) A Dublin based corporate treasurer tells you that she has just negotiated a five-year loan at a competitive fixed rate of interest of 3.2%. The treasurer explains that she achieved the 3.2% rate by borrowing at six-month LIBOR plus 150 basis points and swapping LIBOR for 1.7%. She goes on to say that this was possible because her company has a comparative advantage in the floating-rate market. Explain briefly what issue the treasurer has overlooked. (2 marks) (c) Explain how you would value a swap that is the exchange of a floating rate in one currency for a fixed rate in another currency. (2 marks) (d) Suppose that the term structure of interest rates is flat in the US and UK. The USD interest rate is 2.5% per annum and the GBP rate is 2.9% p.a. Under the terms of a swap agreement, a financial institution pays 3% p.a. in GBP and receives 2.6% p.a. in USD. The principals in the two currencies are GBP20 million and USD32 million. Payments are exchanged every year, with one exchange having just taken place. The swap will last 3 more years NB: Find the current value of the USD/GBP when you complete this question. 0 Write out the formula for the valuation of a currency swap in terms of bond prices. From this formula, explain what prices and/or rates you need to calculate the value of a swap. Show the payments to be made in a table and then calculate the value of the swap to the financial institution. Assume all interest rates are compounded continuously (8 marks) () (e) Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year plain vanilla credit default swap with semi-annual payments. Suppose that the recovery rate is 20% and the unconditional probabilities of default (as seen at time zero) are 1% at times 0.25 years and 0.75 years, and 1.5% at times 1.25 years and 1.75 years. (Explain the mechanics of a standard credit default swap (CDS) using a diagram. (ii) Estimate the credit default swap (CDS) spread in the example above. (iii) Evaluate why CDS markets provide an important barometer of the creditworthiness of corporate bond markets. Question 2 - Swaps (a) Using your own hypothetical examples, critically evaluate any two reasons why investors may use plain vanilla currency swaps. Write out and explain the swaps you have designed. (8 marks) (b) A Dublin based corporate treasurer tells you that she has just negotiated a five-year loan at a competitive fixed rate of interest of 3.2%. The treasurer explains that she achieved the 3.2% rate by borrowing at six-month LIBOR plus 150 basis points and swapping LIBOR for 1.7%. She goes on to say that this was possible because her company has a comparative advantage in the floating-rate market. Explain briefly what issue the treasurer has overlooked. (2 marks) (c) Explain how you would value a swap that is the exchange of a floating rate in one currency for a fixed rate in another currency. (2 marks) (d) Suppose that the term structure of interest rates is flat in the US and UK. The USD interest rate is 2.5% per annum and the GBP rate is 2.9% p.a. Under the terms of a swap agreement, a financial institution pays 3% p.a. in GBP and receives 2.6% p.a. in USD. The principals in the two currencies are GBP20 million and USD32 million. Payments are exchanged every year, with one exchange having just taken place. The swap will last 3 more years NB: Find the current value of the USD/GBP when you complete this question. 0 Write out the formula for the valuation of a currency swap in terms of bond prices. From this formula, explain what prices and/or rates you need to calculate the value of a swap. Show the payments to be made in a table and then calculate the value of the swap to the financial institution. Assume all interest rates are compounded continuously (8 marks) () (e) Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year plain vanilla credit default swap with semi-annual payments. Suppose that the recovery rate is 20% and the unconditional probabilities of default (as seen at time zero) are 1% at times 0.25 years and 0.75 years, and 1.5% at times 1.25 years and 1.75 years. (Explain the mechanics of a standard credit default swap (CDS) using a diagram. (ii) Estimate the credit default swap (CDS) spread in the example above. (iii) Evaluate why CDS markets provide an important barometer of the creditworthiness of corporate bond markets
