Question

Given the following:

Spot Rate Argentine Peso	$0.39
One-year interest rate U.S.	7 percent
One-year Argentine interest rate	12 percent
Futures price = forward price
Interest rate parity exists

Investor purchased futures contracts on Argentine Peso representing 1,000,000 pesos.

Determine the total dollar amount of profit (loss) from this futures contract based on expectation Argentine peso will be worth $0.41 in one year.

Your firm has recently issued some fixed rate debt but would prefer to re-structure the debt using an interest rate swap to a floating rate of debt because your firm believes rates will be trending downward over the next several years. Listed below are the details for the existing debt and the desired floating debt:

Fixed rate debt:		10 percent
Swap payments:		LIBOR plus 1 percent
Expected LIBOR rates:
	End of year 1:	9 percent
	End of year 2:	8.5 percent
	End of year 3:	7 percent

After executing the interest rate swap determine the rate your firm expects to pay on its debt over the next 3 years.

Project Information for firm ABC:

Will export product to Mexico and is looking for firm to swap pesos with over life of project

Time period of project is 4 years

After tax cash flow expected to be 1,000,000 pesos

Peso’s spot rate is $0.20

Risk free annual interest rates: U.S. 6 percent, Mexico 11 percent

Interest rate parity exists

Use one year one year forward rate as predictor of exchange rate in one year

Exchange rates will change by same percentage predicted for year one in years 2 through 4

Firm XYZ will take the 1,000,000 pesos each year at an exchange rate of $0.17 per peso

Ignore taxes

ABCs details:

Capital Structure:	60 percent debt and forty percent equity
Corp. Tax rate:	30 percent
Debt financing cost:	10 percent
US expected stock returns:	18 percent
Beta:	0.9

ABC will use its cost of capital as required return on project

Determine the NPV if ABC enters into a swap agreement with XYZ and does not hedge its position.

Answer 1

Soln : In the first case, when investor purchase future contracts for Argentina peso. Let see as per interest rate parity , what should be the rate of Peso in one year, Let it be F = Spot rate *(1+ r_f)/(1+r_d)

Here rf = foreign currenncy rate = 12%, rd = domestic currency risk free rate = 7%.

So, F = 0.39 * (1.12)/1.07 = 0.41 (approx.) = Expectation of rate of peso. Hence, interest rate parity do exist.

Future of 1 million pesos has been booked. So, Profit /Loss on the position after 1 year = 1000000*(Future rate - spot rate) = 1000000*(0.41-0.39) = $20000

Now, Case for using the swap for fixed rate against the floating rate. As company expect the fall of rate. Year 1 = 9%, Year 2 = 8.5% and year 3 = 7%

So, We can say that Net interest rate paid by the company, cumulative over a period = ((1.09)*(1.085)*(1.07))^0.33 -1 = 1.0861- 1 = 8.61%.

So, we can say that company benefitted with the swap , as they are paying 8.61% each year instead of 10%.

Case : Project of firm ABC

Lets calculate the Cost of Capital for ABC, Cost of equity = 6 + (18-6) *beta = 6 + 12*0.9 = 16.8% (Using CAPM model)

Now, using the WACC formula, cost of capital , r = Debt/Total * cost of debt *(1-tax rate) + equity/total value *cost of equity = 0.6 * 10*(1-0.3) + 0.4*16.8 = 4.2 + 6.72 = 10.92%

Please refer the table as per the swap agreement the ABC will get the following cash flows :

Year	0	1	2	3	4
Cash flow after tax		1000000	1000000	1000000	1000000
Exchange rate ,C		170000	170000	170000	170000
Discount rate		10.92%
Discount factor,d		0.901551	0.812794	0.732775	0.660633
PV = C*d		153263.6	138174.9	124571.7	112307.7

NPV = sum of all PV = 528317.9