Reference no: EM133069611
It's not just commodity prices that have been on the move lately. The differential effects of COVID-19 on different countries has caused significant movements in exchange rates. Such volatile FX markets increase the need for financial derivatives to hedge such volatility, but it can also increase the counterparty risk involved in such derivative trades.
To this end, the financial institution you are working for has a current position in a cross currency interest rate swap and another CHF (Swiss franc) currency futures position. Your boss has asked you to evaluate these two positions.
The Swap Position
20 months ago, your institution entered into a three-year cross-currency interest rate swap with a Swiss pharmaceutical company. The swap agreement was over-the-counter with the following terms: your institution is to pay 2.35% per annum (with semi-annual compounding) in CHF and receive 6-month LIBOR + 0.60% per annum in AUD. Payments are semi-annual and on a notional principal of AUD15 million. The 6-month LIBOR rate and the spot exchange rate at various dates over the last 20 months are shown in the table below:
|
Date of observation
|
6-month LIBOR rate observed
|
Spot exchange rate observed (AUD for 1 CHF)
|
|
t = 0 (contract initiation)
|
1.95%
|
1.6364
|
|
t = 6 months
|
0.52%
|
1.4942
|
|
t = 12 months
|
0.42%
|
1.3911
|
|
t = 18 months
|
0.20%
|
1.4276
|
|
t = 20 months (today)
|
0.15%
|
1.4525
|
(a) Compute the cash flow paid and received by your financial institution on each payment date of the swap (i.e., at t = 0, 6, 12, and 18 months).
(b) Unfortunately for you and your institution, the counterparty to the swap (the Swiss pharmaceutical company) has just filed for bankruptcy with 16 months remaining on the swap agreement. Determine the current value of the swap agreement (and ultimately the cost) to your institution. You should assume that the current interest rate is 1.20% per annum in AUD and 0.15% per annum in CHF (with continuous compounding) for all maturities.
The Futures Position
(c) Worried about a volatile exchange rate, eight months ago your institution also entered into a short position in 2-year currency futures contracts on CHF10 million. At the time, the interest rate was 1.55% per annum in AUD and 0.10% per annum in CHF (with continuous compounding) for all maturities. Your boss asks you the following questions:
i. What was the value of the futures position eight months ago? ii. If we closed out the position today, what would be the profit/loss on the futures transaction?[1]