So many problems with this question set! Consider a 3-yr annual currency swap that takes place between a foreign firm (FF) with FC currency units and a US firm (USF) with $ units. USF is the fixed rate payer and FF is the floating rate payer. The fixed interest rate at the initiation of the swap is 7% and 8% at the end of the swap. The variable rate is 5% currently, 6% at the end of year 1, 8% at the end of year 2, and 7% at the end of year 3. The exchange rate is FC 2 = $1 at the end of year 1, and FC 1.5 = $1 at the end of the swap period At the end of year 2: A. USF pays FC 140K, FF pays $60K B. USF pays FC 60K, FF pays $70K C. USF pays $70K. FF pays FC 60K The book claims (A). I claim the answer is: USF pays FC 140K, FF pays $80K, which is not listed in the answer choices? Why does the book use the rate at the end of year 1, shouldn’t it be the rate at the end of year 2 that is paid? At the end of year 3, FF will pay which of the following total amounts? A. $1.08MM B. $1.07MM C. FC 2.16MM The book says (A). Why isn’t it B? At the end of year 3, the floating rate is 7%, but the book uses 8% to calculate their answer. Lambda Corp has a floating rate liability and wants a fixed-rate exposure. They enter into a 2-year quarterly pay $4MM fixed for floating swap as the fixed rate payer. The counterparty is Gamma corp. The fixed rate is 6% and the floating rate is the 90-Day LIBOR + 1%, which are both calculated using a 360-day year. LIBOR is: Current: 5% In 1 Quarter: 5.5% In 2 Quarters: 5.4% In 3 Quarters: 5.8% In 4 Quarters: 6% The first swap payment is: A. From Gamma to Lambda B. Known at the initiation of the swap C. $5K The book says (B). Why isn’t it A? At the initiation of the swap, there is no payment, the payment in 1 quarter is the first swap payment from Gamma to Lambda. The second net swap payment is: A. $5K from Lambda to Gamma B. $4K from Gamma to Lambda C. $5K from Gamma to Lambda The book says ©. Why isn’t it B? The second swap payment is in 2 quarters, where a rate of 5.4% is used. (5.4% + 1) - 6% = 0.4% per year, or 0.1% for the quarter. That’s $4K. The book uses a rate of 5.5%, does anyone know why?
I think you should reread. Most swaps are in arrears. So 6% would be the rate for the floating side of the swap for problem 1. 6% known floating at the end of year 1 would be used to settle for year 2, Floating rate at end of year 2 would be used for year 3. most of your issues should be resolved once you use the above.
NYCAnalyst86 Wrote: ------------------------------------------------------- > So many problems with this question set! > > Consider a 3-yr annual currency swap that takes > place between a foreign firm (FF) with FC currency > units and a US firm (USF) with $ units. USF is the > fixed rate payer and FF is the floating rate > payer. The fixed interest rate at the initiation > of the swap is 7% and 8% at the end of the swap. > The variable rate is 5% currently, 6% at the end > of year 1, 8% at the end of year 2, and 7% at the > end of year 3. The exchange rate is FC 2 = $1 at > the end of year 1, and FC 1.5 = $1 at the end of > the swap period First off, what’s the notional principal? ($1M USD since the answer is A). > At the end of year 2: > > A. USF pays FC 140K, FF pays $60K > B. USF pays FC 60K, FF pays $70K > C. USF pays $70K. FF pays FC 60K > > The book claims (A). I claim the answer is: USF > pays FC 140K, FF pays $80K, which is not listed in > the answer choices? Why does the book use the rate > at the end of year 1, shouldn’t it be the rate at > the end of year 2 that is paid? > You’re supposed to use the rate at the beginning of the period. To calculate the payment at the end of year 2, use the beginning of period rate which is 6%. Thus, the answer is A > > At the end of year 3, FF will pay which of the > following total amounts? > > A. $1.08MM > B. $1.07MM > C. FC 2.16MM > > The book says (A). > > Why isn’t it B? At the end of year 3, the floating > rate is 7%, but the book uses 8% to calculate > their answer. > Same explanation of above. Beginning of year rate is 8% so the payment is $80K + the notional principal. For the last 2 questions, it’s the same issue. You have to use the correct rate.
The answer to your first question should be A. At the end of year 2 there wont be any exchange on money, because they have not stated the fixed interest rate for year 2. Only 2 fixed interest rates are stated (7% and 8%). So we will go with 7% payment in Foreign curreny - 140K FC (or 70K USD). The interest rate at end of year 1 is used to make payments at end of year 2. Option C is out of question (USF does not pay in dollars). Option B is wrong too, because at no point in comparision is fixed rate less than floating rate. So payment from USF to FF cannot be less than the payment from FF to USF. For question 2, my best guess is that the answer should be 1.08 (A). The floating rate at the end of year 2 is 8%, this rate is applied throughout the year 3 and the year 3 payments are actually based on interest at end of year 2. I dont get the first part of Lamda question. But the answer to second part should be 5k (option C). I think the book assumes that the 90 day LIBOR means that current rate is used for the first quarter ie 5%, 5.5%is used for the payment at the end of quater 2. As explained above, this payment is based on the interest at the end of quarter 1.
Good question! I don’t quite get how the exchange rate comes into play here. I suppose I got the below correct? End of year 2 USF pays 7% FC FF pays 6% End of year 3 USF pays 8% FC FF pays 8%
Q2. At the end of year 3, FF will pay which of the following total amounts? A. $1.08MM B. $1.07MM C. FC 2.16MM FF is paying on the $side of the leg. So exchange rate plays no part. Key thing to realize is a. it is a currency swap. so the entire “principal” of 1MM USD would be returned at the end. b. 8% interest on the principal (from end of year 2 on the floating side) will be paid back as well. Q3. Lambda Corp has a floating rate liability and wants a fixed-rate exposure. They enter into a 2-year quarterly pay $4MM fixed for floating swap as the fixed rate payer. The counterparty is Gamma corp. The fixed rate is 6% and the floating rate is the 90-Day LIBOR + 1%, which are both calculated using a 360-day year. LIBOR is: Current: 5% In 1 Quarter: 5.5% In 2 Quarters: 5.4% In 3 Quarters: 5.8% In 4 Quarters: 6% The first swap payment is: A. From Gamma to Lambda B. Known at the initiation of the swap C. $5K First period - Lambda will pay 5% (end of period 1) + 1% = 6%. Will receive 6% fixed. so no swap payment. (A) is wrong. So is ©. However - you can calculate the amount at the swap initiation. So (B) is right. Q3. The second net swap payment is: A. $5K from Lambda to Gamma B. $4K from Gamma to Lambda C. $5K from Gamma to Lambda Fixed=6% Gamma pays Lambda Floating=5.5%(End of period 2) + 1 = 6.5% which Lambda pays Gamma. so net 0.5% on 4MM / 4 (for quarter) paid by Lambda to Gamma = 5000 So my answer is (A). I think the book answer is wrong based on the above calculations.