Question

Question 4

Given the following swap rates, Charlton Ferguson, Chief Finance Officer of Red Devils Ltd., decides to enter into a four-year currency swap agreement to receive pounds and pay euros, on a notional principal of £33,000,000. The spot exchange rate at the time of the swap is €1.8300/£.

          Swap Rates

          Years           £ bid £ ask            € bid € ask

          2                  4.08% 4.28%           3.10% 3.30%

          3                  4.18% 4.33%           3.25% 3.48%

          4                  4.23% 4.48%           3.30% 3.60%

a)       Calculate all principal and interest payments, in both pounds and euros, over the life of the currency swap agreement.

b)       Assuming that two years into the swap agreement, Charlton Ferguson decides to unwind the swap agreement and settle it in pounds. Assume that a two-year fixed rate of interest on pounds is 4.50%, a two-year fixed rate of interest on euros is 3.80%, and the spot rate of exchange is now €1.7788/£. Find the net settlement amount of unwinding the swap and state who pays to whom the net settlement amount (Red Devils Ltd. pays to swap dealer or swap dealer pays to Red Devils Ltd.).

Answer 1

a.) currency swap is a contract under which a particular amount of one currency is exchanged for another currency at a predetermined rate.

Principle amount= £33,000,000

spot exchange rate =€1.8300/£.

swap rate for 2 years with bid and ask at 4.08% and 4.28% respectively in case swap contract is £ for €

Therefore, the maturity value of the contract at bid price of 4.08%

=principle * (1+bid rate)^(duration)

=

= £35747733.12

Therefore, the interest received over two years=maturity value - principle value = £35747733.12-33000000= £2747733.12

Therefore similarly the maturity value of the principle at exchange rate of 3 years with bid rate 4.18%

=

= £37313587

Therefore, the interest received = £4313587

Therefore, the maturity value of the principle amount after 4 years at bid rate 4.23%=

= £38947976

The interest received for the duration of four years at bid rate on principle amount of £33000000= £38947976- £33000000= £5947976

Now, we need to convert the £ into € using swap exchange rate such that 1£ = €1.8300

Therefore, the notional principle amount in € currency = €1.83*33000000=€60390000

Therefore, the maturity value at the end of 2 years if bid rate is 3.10%=

=€ 64192215

Therefore, the total cumulative interest payment  after two year contract = maturity value - principle amount = € 64192215 - €60390000= €3802215

similarly the maturity value of the contract after three years if bid rate is 3.25% =

=

=€66471459

Therefore, the total cumulative interest payment after three years = €66471459 - €60390000=€6081459

similarly, the maturity value of the contract after four years at bid rate 3.30% =

=

=€68764821

Therefore, the total cumulative interest payment for 4 years = €68764821 - €60390000= €8374821

b.)

The maturity value of the contract after two years if bid rate is constant at 4.50% =

=£36036825

Therfore, if  charlton ferguson enters into a fixed rate swap contract at bid rate 4.50% then, swap dealer needs to pay the red devils ltd the amount that red devils ltd didn't received due to variable swap exchange rate = 36036825 - 35747733.12=£ 289091.88

similarly due to fixed swap rate and reduced spot exchange rate at €1.7788/£ . The red devils payment at the end of second year = 33000000 * 1.7788 * (1.0380)^2 = €63246394. hence, the red devils paying less amount if they enters into a fixed swap rate contract.

Therefore, red devils needs to compensate the swap dealer for the loss due to fixed swap rate .The amount to be compensated = €64192215 - €63246394= €945821 app.