To compute: The swap rate on an agreement to exchange currency over a 3-year period supposing the U.S. yield curve is flat at 3% and the current exchange rate is $1.20 per euro.
Introduction:
Swap rate: Swap rate refers to that rate of interest which is applicable during the exchange of currency between two different countries. By swapping, the companies are benefitted by hedging against interest rate exposure. This is possible only when the uncertainty of cash flows is reduced.
Answer to Problem 21PS
The swap rate per year would be $1223100.
Explanation of Solution
U.S. yield curve = 4%
Euro yield curve =3%
Current exchange rate= $1.20 per euro
Amount to be exchanged= $1 million
We are asked to calculate the swap rate to exchange 1 million euros for a given number of dollars in each year.
The formula used is as follows-
Where
F1, F2, F3 = Price to be paid the period 1,2 and 3.
F*= Constant rate to be paid in 3 years
y1,y2,and y3 = Yields
The formula to calculate forward price is as follows:
Let us assign values to the variables in the formula.
E0= $1.20 per euro
U.S. Yield rUS=4% (when we convert it by dividing it by 100 we get 0.04)
Euro yield rEU=3% (when we convert it by dividing it by 100 we get 0.03)
Now, we have to consider each contract as a separate contract and then calculate the forward price for each period.
Calculation of forward price for 1styear:
Let F1 be the forward price of first year.
Therefore the forward price is $1.2108
Therefore, the dollars to be delivered in first year will be $1.2108 million.
Calculation of forward price for 2nd year:
Let F2 be the forward price of second year.
Therefore the forward price for second year is $1.2234.
Therefore, the dollars to be delivered in second year will be $1.2234 million.
Calculation of forward price for 3rd year:
Let F3 be the forward price of third year.
Therefore the forward price is $1.2351.
Therefore, the dollars to be delivered in third year will be $1.2351 million.
Let us now calculate the swap rate. But before that we have to calculate the constant number of dollars F* to be delivered each year.
Therefore, the swap rate per year would be $1223100.
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Chapter 23 Solutions
INVESTMENTS
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