Swaps-April 05 Q7

April 05 Q7:

In the case of a currency swap arranged through a bank

1) ACTED Solution says that initially the value of the swap to the bank is zero. Shouldn't the two swaps be worth in total 0.45% for the bank?Otherwise there is no reason for the bank to do the deal! In fact only the swap rate makes a swap have a zero value.

2) ACTED Solution says that to hedge the currency risk the bank should buy sterling forward. Doesn't this assume that the bank is US based?!!!

April 07 Q8:

ACTED solution says that the swap arrangement should be 2% Yen and 4.5% GBP. However this leaves the customer with exchange rate risk and hence makes the solution wrong. It think it should be 5.75% GBP and 3.25% Yen

 

Anyone???

 

1) Agree, depends how the swaps are set up but they shouldnt have zero values I wouldnt have thought. One might, but not both surely?

2) Doesnt matter where they are. Its because they make profit in $. So need to hedge the $ value against depreciation relative to £ otherwise they could end up making a nominal loss. If they made their profit in £ it would be the opposite way round.

 

April 05 Q7...
1) I don't have the Acted solutions, but had a quick look at the examiner's report. To get to the point of desiging a swap with 0.45% margin to the bank you first need to set up two individual swaps with the borrowers on a zero-cost basis (this will have zero value to the bank), and then tilt the charges to end up with the 0.45% margin when the two arrangements are combined (to cover fees, credit risk etc).

Questions often show this kind of scenario where there are two companies wanting to do equal and opposite deals with the bank, it is rarely the case in practice. You should probably get a comment or two in your answer about warehousing swaps by the inv bank + related risks of doing so (if asked for risks to the investment bank).

2) Examiners solution merely mentions foreign exchange futures, without specifying a specific currency. When in doubt...

 

-Isn't it the same a selling dollars forward?

 

yeah, selling dollars forward is the same as buying pounds forward.

You are agreeing to trade your dollars (your profit) at a guaranteed rate.

I guess you would want to close it out before maturity though? You dont actually want to trade the currency, you just want a payoff if the $ devalues to compensate for your reduction in profit.