Question

Question 4

Red Balloons Ltd, a Canadian supplier of military radar equipment, has just won a bid to lease the Spanish Air Force some high-end sensors for the next ten years. The first of 20 semi-annual payments of €5.3 million will be made on January 1, 2013.

1. Assuming Red Balloons will need to convert Euros into dollars before they can pay their expenses, does this contract provide them with a long or short exposure to the Canadian Dollar? Explain. (1 mark)

To manage their risk, Red Balloons contacted the swap desk at their bank who offered to buy their foreign currency every six months for a rate of $1.2585 CAD per Euro for the length of the contract.

2. If Red Balloons accepts the offer, will the bank have a long or short exposure to Euro as a result of this new contract? Explain with a diagram showing both transactions between the three parties
3. When banks take on these kinds of currency risks and enable their clients to hedge, they neutralize their own exposures by swapping the foreign currency to banks domiciled in the originating country. If the Canadian bank needs to make a present value of $465,000 from arranging this swap to cover their costs, and the appropriate semi-annual discount rate is 2%, what is the lowest price in dollars that the Canadian bank can accept for the Euros they will resell? Keep 4 decimal places.
4. In the case of cross-currency swaps like this, the entire amounts are exchanged each time, not simply a net payment. Explain why this is. (1 mark)

Read the following story and comment briefly on why the manipulation of LIBOR had important consequences for the market for interest rate swaps. Who profited from the underreporting of LIBOR? How could a bank profit by reporting a lower borrowing rate than they actually had?

Answer 1