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Question 2 Currency Swaps Suppose the effective annual euro-denominated interest rate is 1.5% p.a. and the dollar- denominated rate is 3% p.a.. The spot exchange rate is $0.85/. A dollar-based firm has a 3- year 1.5% p.a. (annually compounded) euro-denominated bond with a 100 par value and price of 100. The firm wishes to guarantee the dollar value of the payments. (a) Since the firm will make debt payments in euros, it buys the euro forward to eliminate currency exposure. Please complete the following table and prove that hedging does not change the value of the debt. Unhedged Euro Cash Forward Exchange Hedged Dollar Cash Year Flow Rate Flow 1 0.8626 2 0.8753 3 0.8882 Hints: 1) At the end of each year, the firm is liable to pay a coupon of 1.5% on 100 par value (i.e. = 1.5). 2) To prove hedging does not change the value of the debt, you should demonstrate the present value of the hedged cash flows is approximately equal to the price of the bond. (b) As an alternative to hedging each euro-denominated payment with a forward contract, the firm can enter into a 3-year currency swap, which entails to receive euros 1.5% p.a. (annually compounded) on 100 bond and pay dollars 3% p.a. (annually compounded) on a $85 bond). Please complete the following table and calculate the value of the swap to the market maker, who acts as the counterparty to the firm. Euro CFs in Dollars Net CFs In Dollars PV Factor Cash Flows for the Market-Maker Forward Dollar Year Exchange CFs Rate 1 0.8626 2 0.8753 3 0.8882 PV of Net Dollar CFs Question 2 Currency Swaps Suppose the effective annual euro-denominated interest rate is 1.5% p.a. and the dollar- denominated rate is 3% p.a.. The spot exchange rate is $0.85/. A dollar-based firm has a 3- year 1.5% p.a. (annually compounded) euro-denominated bond with a 100 par value and price of 100. The firm wishes to guarantee the dollar value of the payments. (a) Since the firm will make debt payments in euros, it buys the euro forward to eliminate currency exposure. Please complete the following table and prove that hedging does not change the value of the debt. Unhedged Euro Cash Forward Exchange Hedged Dollar Cash Year Flow Rate Flow 1 0.8626 2 0.8753 3 0.8882 Hints: 1) At the end of each year, the firm is liable to pay a coupon of 1.5% on 100 par value (i.e. = 1.5). 2) To prove hedging does not change the value of the debt, you should demonstrate the present value of the hedged cash flows is approximately equal to the price of the bond. (b) As an alternative to hedging each euro-denominated payment with a forward contract, the firm can enter into a 3-year currency swap, which entails to receive euros 1.5% p.a. (annually compounded) on 100 bond and pay dollars 3% p.a. (annually compounded) on a $85 bond). Please complete the following table and calculate the value of the swap to the market maker, who acts as the counterparty to the firm. Euro CFs in Dollars Net CFs In Dollars PV Factor Cash Flows for the Market-Maker Forward Dollar Year Exchange CFs Rate 1 0.8626 2 0.8753 3 0.8882 PV of Net Dollar CFs
