Financial Market product

mayankmundhra30
Good Student
Posts: 23
Joined: Sat Jun 25, 2016 8:13 am

Financial Market product

Postby mayankmundhra30 » Sat Aug 20, 2016 1:28 pm

i have doubts in the following questions
1) You are given the following information about an interest rate swap: 2-year Term Semi-annual payment Fixed Rate = 6 % Floating Rate = LIBOR + 50 basis points. Notional principal USD10 million. Calculate the net coupon exchange for the first period if LIBOR is 5% at the beginning of the period and 5.5% at the end of the period.
Choose one answer.
a. Fixed rate payer pays USD 25,000. Correct
b. Fixed rate payer receives USD 25,000. Incorrect
c. Fixed rate payer pays USD 0. Incorrect
d. Fixed rate payer pays USD 50,000. Incorrect
Please explain how to do it. Is 6% annual or semi annual payment. does the payment happen at the beginning or at the end of the period?

2) The following are the net currency positions of a financial institution. Net currency positions are defined as foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

Choose one answer.
a. The financial institution is net short in the Deutsche mark and, therefore, faces the risk that the Deutsche mark will rise in value against the U.S. dollar. Correct
b. The financial institution is net short in the Japanese yen and, therefore, faces the risk that the Japanese yen will fall in value against the U.S. dollar Incorrect
c. The financial institution is net long in the British pound and, therefore, faces the risk that the British pound will fall in value against the U.S. dollar. Incorrect
d. The financial institution is net long in the Swiss franc and, therefore, faces the risk that the Swiss franc will rise in value against the U.S. dollar Incorrect

Why option c is incorrect? please explain all the options.

3) BNP Paribas has just entered into a plain-vanilla interest-rate swap as a pay-fixed counterparty. Credit Agricole is the receive fixed counterparty in the same swap. The forward spot curve is upward-sloping. If LIBOR starts trending down and the forward spot curve flattens, the credit risk from the swap will:
Choose one answer.
a. Decrease for both BNP Paribas and Credit Agricole. Incorrect
b. Increase only for BNP Paribas. Incorrect
c. Increase for both BNP Paribas and Credit Agricole. Incorrect
d. Increase only for Credit Agricole. Correct
I think credit risk is higher for BNP. BNP might default.

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

Re: Financial Market product

Postby edupristine » Fri Aug 26, 2016 10:42 am

1) Fixed rate payer pays 6%, therefore (0.06 / 2) x 10 million = USD 300,000.
Interest rate swaps have payments in arrears. Floating rate payer pays LIBOR rate at the beginning of period + 0.50%, i.e. 5 % + 0.50% = 5.5 %.
Therefore the floating rate payment = (0.055 / 2) x 10 million = USD 275,000.
The net payment of USD 25,000 is paid by the fixed rate payer.

2) All the currencies have been considered. The relevance of S.D. is not much in this question except that the presence of S.D. implies risk.
Net currency position = Exchange bought - Exchange sold
Therefore, positive net currency position implies net long position,
negative net currency position implies net short position
If we are net short, i.e, we have sold more in futures/ forwards, then if prices rise later, we will buy from open market at higher price and deliver at the contracted lower price. Therefore, in net short position, risk arises if exchange rate (price of currency) rises.
If we are net long, i.e, we have bought more in futures/ forwards. Then if prices fall later, we will be buying at the contracted higher price. Therefore, in net long position, risk arises if exchange rate (price of currency) falls.
Let us look at the answer options.

a) Is correct - because net currency position is (-$2,50,000), hence we are net short. Also, risk arises only if DM rates rise.
b) Is incorrect - because net currency position is $5,30,000, i.e., we are net long, not net short
c) Is incorrect - because net currency position is (-$455,3501), i.e., we are net short, not net long.
d) Is incorrect - because even though we are net long in the Swiss franc , risk arises only if Swiss franc falls, not if it rises in value against the U.S. dollar.
I hope we have answered your query.

3) BNP will pay Credit Agricole a fixed rate of interest at every interval and will receive floating rate of interest from Credit Agricole that is LIBOR. Now it is said that LIBOR has started trending down which means BNP will end up paying more interest than receiving from Credit Agricole. The risk in this case is that BNP may default on its obligation since it is paying a higher rate of interest than the market, which increases credit risk for Credit Agricole.

mayankmundhra30
Good Student
Posts: 23
Joined: Sat Jun 25, 2016 8:13 am

Re: Financial Market product

Postby mayankmundhra30 » Fri Aug 26, 2016 1:55 pm

Thank you for clarifying the doubts.


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