Suppose that the term structure of interest rates is flat in the US and UK. The USD interest rate is 1.4% per annum and the GBP rate is 1.7% p.a. Under the terms of a swap agreement, a financial institution pays 2% p.a. in GBP and receives 1.6% p.a. in USD. The principals in the two currencies are GBP100 million and USD140 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

 

1. 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.
2. 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.