Question

On 1 January 2017, Dayco Ltd entered into a 5 year cross currency interest rate swap with JP Morgan, a financial institution which specialises in foreign currency swaps. Dayco wishes to receive US Dollars (USD) and pay Japanese Yen (JPY) through this swap contract. The swap has a notional principal of $5,000,000 USD. The interest on each currency is to be exchanged at the end of each year.

The current spot exchange rate is 107YEN /USD. The 5 year forward rate is 91YEN /USD. The 5 year fixed rate is 5% p.a. for USD and the 5 year fixed rate is 2% p.a. for YEN.

The annual swap rate (annual) quoted by JP Morgan for USD and YEN is as below:

Time	USD		JPY
	Bid	Ask	Bid	Ask
3 year	2.42%	2.44%	1.25%	1.28%
5 year	3.32%	3.34%	1.49%	1.53%
7 year	2.99%	3.03%	0.76%	0.79%

For this currency swap the two companies have agreed to exchange the notional principal amounts in USD and YEN as means of collateral on the day the currency swap is signed.

Required:

1. What are the notional principal amounts to be used as collateral in this cross currency interest rate swap?
2. What are the amounts Dayco will pay to JP Morgan at the end of each year until the end of the swap?
3. On 1 January 2020, 3 years after the swap contract was signed, Dayco decides to terminate the swap contract and has asked JP Morgan to unwind the swap. At this point the swap contract has 2 years to maturity. The following quotes were available.
   • The spot exchange rate is 110JPY /USD
   • The 2 year forward rate is 102JPY /USD
   • The 2 year fixed (i.e. discount rate) for USD is 3.5% p.a.
   • The 2 year fixed (i.e. discount rate) for JPY is 0.75% p.a.

   What is the net settlement of unwinding the swap contract for Dayco?

4. Foreign currency swaps, such as the contract discussed in question (a) to (c), are used to hedge risks, such as interest rate risk. Name and describe one other financial instrument that can be used to hedge against interest rate risk?

Answer 1

The Notional Principal to be used as collateral are : USD 5 million and YEN 5 million*107 = YEN 535 million

i.e. Dayco will deposit USD 5 million with JP Morgan and receive YEN 535 million from JP Morgan.

The swap rates agreed are Dayco will receive the 5 year USD bid rate i.e. 3.32% every year and pay the ask rate for YEN i.e. 1.53% at the end of every year

So, Dayco will receive $5 million *3.32% = $166,000 at the end of every year and

Dayco will pay Yen 535 million * 1.53%= YEN 8,185,500  at the end of every year

The swap with two years remaining can be valued in terms of $ and YEN bonds

Value of $ bond today= 166000/1.035 + 166000/1.035^2+ 5000000/1.035^2 = $4982902.75

Value of Yen bond today= 8185500/1.0075 + 8185500/1.0075^2+ 535000000/1.0075^2 = YEN 543,253,037.70

Value of Swap to Dayco (in $) = Value of Dollar bond - value of Yen bond / exchange rate

=4982902.75 - 543253037.70/110

=4982902.75 - 4938663.98

= $44238.77

So, JP Morgan will pay $44238.77 to Dayco to unwind the contract.

Eurodollar futures can also be used to hedge interest rate risk. It is used by the companies to fix the interest rate at which they want to borrow or lend in future. It basically sets the interest rate of Dollars in international markets in the future. It is widely used by many companies to hedge their interest rate exposure.