Hey LIIers, I posted this question on the LIII forum (as I am LIII candidate, oh yeah!) but thought some of you here might be able to enlighten me: Hello, Hopefully some of you can help me understand the answer to a question I was asked in an interview. Thankfully, I pretty much guessed the right answer but the maths of it are still unknown to me. Should consult the books, I suppose… Anyway, q goes something like: A perfect hedge, pay Euribor, receive USD fixed. What will be the income generated from this swap? Answer: USD money market rate. I guess this is to do with the FX rate interest-rate differential but if anyone can give me a definitive answer, I would appreciate it. It’s keeping me awake at night… Many thanks.
post it on wilmott.com. if its a prefect hedge, shouldnt there be no income…as rates rise in the US, the USD depreciates. in theory at least.
mrdjb Wrote: ------------------------------------------------------- > Hey LIIers, > I posted this question on the LIII forum (as I am > LIII candidate, oh yeah!) but thought some of you > here might be able to enlighten me: > > Hello, > Hopefully some of you can help me understand the > answer to a question I was asked in an interview. > Thankfully, I pretty much guessed the right answer > but the maths of it are still unknown to me. > Should consult the books, I suppose… > Anyway, q goes something like: > > A perfect hedge, pay Euribor, receive USD fixed. > What will be the income generated from this swap? > > > Answer: USD money market rate. > > I guess this is to do with the FX rate > interest-rate differential but if anyone can give > me > a definitive answer, I would appreciate it. > It’s keeping me awake at night… > > Many thanks. This is a “perfect hedge”, which means any depreciation of the USD or appreciation is offset by the returns. There is no room for arbitrage profits and from the end of the US Investor, the income will be the money market rate. The European counterpart will also end up with the Euro money market rate in the same transaction. Question is why is it the money market rate that is earned and not the risk free rate? The answer is because the world is gradually shifting to the use or AAA rated financials, incorporated into LIBOR, EURIBOR, etc to create swap contracts.
If I understand your question correct, The logic should be like this: If it is fixed rate swap, either US interest rates must be higher than Eurobor or dollar must be appreciated to pay lump sum Euro amount at the end. Second case, there must be a swaption hedge with higher fixed pay in Euro.