Suppose that the term structure of interest rates is flat in the United States and Switzerland. The dollar interest rate is 5.8% per annum, and the market interest rate is 4.2% per annum. The current exchange rate is 2.71 Swiss francs per dollar. Under the terms of a swap agreement, a financial institution pays 5% per annum in Swiss francs and receives 7.0% per annum in dollars. The principals in the two currencies are 10 million dollars and 30 million Swiss francs. Payments are exchanged every year, with one exchange having just taken place. The swap will last for two more years.

Required

1. What is the value of the swap to the financial institution? Assume all interest rates are continuously compounded.

(5 marks)

2. How you would value a swap that is the exchange of a floating rate in one currency for a fixed rate in another currency? Explain in detail.

(5 marks)

Companies Alpha Plc and Bravo Plc face the following interest rates (adjusted for the differential impact of taxes):

	Alpha plc	Bravo Plc
US Dollars (floating rate)	LIBOR+0.4%	LIBOR+1.4%
Swiss Francs (fixed rate)	4.9%	5.9%

Assume that Alpha Plc wants to borrow U.S. dollars at a floating rate of interest and Bravo Plc wants to borrow Swiss Francs at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 50-basis-point spread.

Required

3. If the swap is equally attractive to Alpha and Bravo, what rates of interest will Alpha and Bravo end up paying?

(5 marks)

4. Are there any kinds of risk the bank is exposed to when it enters into two offsetting swap contracts?

(5 marks)

5. Critically discuss the comparative advantage argument in relation to swaps.

(5 marks)

(Total 25 marks)