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There are two companies, A and B. They have the following fixed and floating borrowing costs: A B Fixed rate borrowing 5.

1. There are two companies, A and B. They have the following fixed and floating borrowing costs:

 A   B

Fixed rate borrowing 5.5%    7%

Floating rate borrowing LIBOR LIBOR + 1%

A desires to borrow floating rate and B desires to borrow fixed. Both companies would like a 5 year loan for $100,000,000.

(a) Design a fixed-floating swap in which A and B will have an equal cost savings in their borrowing costs as compared to borrowing directly without the swap. Show the costs to each party after the swap.

(b ) If A and B contact a bank instead of each other, how much would each company be willing to pay the swap bank to take the other side of the swap? Describe in term of percentage fee the bank is charging. 

2. Company X has a 5 year loan that pays interest every six months at a floating rate that is adjusted every six months and is currently at 4% (quoted as an annual rate). If this rate is expected to increase every six months by .5% (quoted as an annual rate), what is a fair interest rate (annualized) for the fixed side of a fixed for floating swap for Company X's loan? 

3. Company A is a US company that would like to borrow in Euros to fund an expansion in European Union markets. Company B is a European company that wants to borrow in the US to fund expansion in the US. The following chart shows the rates at which the 2 companies can borrow:

 A   B

US borrowing ($)  5%    6%

Euro borrowing (€)  3%      2%

If the current exchange rate is $1.25 = 1 €, calculate the following details of a currency swap where A borrows $100,000,000 for 5 years in the US and B borrows 80,000,000 € for 5 years in European markets:

(a) Show the cash flows for both parties if the currency swap requires exchanges every six months.

(b) Calculate the present value of the cash flow going out and coming in from the perspective of A.

(c) Show the implied forward rate of each payment as compared to the actual forward rate

(d) Describe the currency risk of A under the swap contract.

4. A US company will be selling a large machine to a company in Mexico exactly one year from now in exchange for a payment of 20,000,000 Mexican Pesos. You are an analyst who is considering different ways of hedging this risk exposure.

(a) Forward Market Hedge:

(i) Find the appropriate forward rate for a 12 month forward from Calculate the position you should take in the forward market to hedge the cash flow. 

(ii ) Draw a diagram showing the value of the large payment expressed in US dollars if the spot exchange rate changes by the following amounts over the next year: -20%, -15%, -10%, -5%, 0, 5%, 10%, 15%, 20%. Show separately the unhedged position, the forward contract and the net position.

(b) Futures Market Hedge:

Describe three differences if you used a futures contract to hedge in (a) instead of a forward contract

(c) Money Market Hedge:

Describe the steps you would take to hedge by borrowing money in one market, converting it to other currency and investing it. (Assume you can borrow and lend in the US at 2% and in Mexico at 7.5%). 

(d ) Hedge with Options:

Use the quote from the CME group at the options tab on the futures page to select a strike price and obtain a price for an appropriate option. Draw a diagram that shows the (i) unhedged position, (ii) the value of the hedge, and (iii) the net position in US dollars that will be received if the exchange rate changes by -20%, -15%, -10%, -5%, 0, 5%, 10%, 15%, 20%

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