FIN 4604 FIU Interest Rates and Currency Swaps & Economic Exposure Questions

Please review the attached slides. Then answer the questions in question/answer format. There is no minimum of words required (just answer the questions)

1. How would you define economic exposure to exchange risk?

2. Explain the following statement: “Exposure is the regression coefficient.”

3. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.

4. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.

5. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth \$1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., \$1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

a. Estimate your exposure (b) to the exchange risk.

b. Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty.

c. Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging.

6. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?

7. Discuss the basic motivations for a counterparty to enter into a currency swap.

8. Discuss the risks confronting an interest rate and currency swap dealer.

9. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 – 8.10 percent annually against six-month dollar LIBOR for dollars and 11.25 – 11.65 percent annually against six-month dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into a \$/£ currency swap?

10. A U.S. company needs to raise €50,000,000. It plans to raise this money by issuing dollar-denominated bonds and using a currency swap to convert the dollars to euros. The company expects interest rates in both the United States and the euro zone to fall.

a. Should the swap be structured with interest paid at a fixed or a floating rate?

b. Should the swap be structured with interest received at a fixed or a floating rate?

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