A financial institution has entered into a 10-year currency swap with company Y. Under the terms...

A financial institution has entered into a 10-year currency swap with company Y. Under the terms of the swap, the financial institution receives interest at 3% per annum in Swiss francs and pays interest at 8% per annum in U.S. dollars. Interest payments are exchanged once a year. The principal amounts are 7 million dollars and 10 million francs. Suppose that company Y declares bankruptcy at the end of year 6, when the exchange rate is $0.80 per franc. What is the cost to the financial institution? Assume that, at the end of year 6, the interest rate is 3% per annum in Swiss francs and 8% per annum in U.S. dollars for all maturities. All interest rates are quoted with annual compounding.

The LIBOR zero curve is flat at 5% (continuously compounded) out to 1.5 years. Swap rates for 2- and 3-year semiannual pay swaps are 5.4% and 5.6%, respectively. Estimate the LIBOR zero rates for maturities of 2.0, 2.5, and 3.0 years. (Assume that the 2.5-year swap rate is the average of the 2- and 3-year swap rates and use LIBOR discounting.)

Solutions

Expert Solution

The Formula for Forward rate with annual compounding is

Where Fo is T year forward rate. So is spot rate, r is domestic risk free rate, rf is foreign risk free rate. It is calculated using this formula

Year	T	Spot rate	8%
7	1	1 yr Fwd	0.083883
8	2	2 yr Fwd	0.087956
9	3	3 yr Fwd	0.092225
10	4	4 yr Fwd	0.096702

Assuming that forward rates are realised, the Cash flow lost as a result of default is calculated as below

	Year	$ paid	CHF received	Fwd rate	$ equivalent of CHF received	Cash Flow	Discount factor@8%	Discounted CF	Total
	6	$560,000	CHF 300,000	0.800000	$240,000.00	-$320,000.00	1	-$320,000.00	$680,000.00
	7	$560,000	CHF 300,000	0.838835	$251,650.49	-$308,349.51	0.925926	-$285,508.81
	8	$560,000	CHF 300,000	0.879555	$263,866.53	-$296,133.47	0.857339	-$253,886.72
	9	$560,000	CHF 300,000	0.922252	$276,675.58	-$283,324.42	0.793832	-$224,912.06

	10	$560,000	CHF 300,000	0.967021	$290,106.44	-$269,893.56	0.73503
	10	$7,000,000	CHF 10,000,000	0.967021	$9,670,214.56	$2,670,214.56	0.73503
Total	10	$7,560,000	$10,300,000	0.967021	$9,960,321	$2,400,321	0.73503	$1,764,307.59

Thus exchange has positive value at the end of six year and value is $680,000. It makes no sense for Y to default after 6 years. Thus bankruptcy may not be because of this contract

jeff jeffy answered 1 year ago

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