THBMBU002

MNCSIB003
Chapter 7

Problem 7.1
Company B pays higher rates of interest in both the fixed and floating rate market because it
is less credit worthy than A.
The difference between fixed rates is 1.4% (=6.4%-5.0%)
The difference between floating rates is 0.5%.

Therefore:
A has a comparative advantage in the fixed-rate markets. Therefore A will borrow floating
rate funds at 5.0% pa
B has a comparative advantage in the floating-rate markets. Therefore B will borrow floating
rate funds at L + 0.6% pa

Total benefit to all parties = (6.4 - 5.0) - (L+0.6 - L+0.1) = 0.9% pa

Since FI earns 0.1%, then Company A gains 0.4% pa and Company B also gains 0.4% pa

This means the swaps should result in A having a net borrowing at L – 0.3% pa and,
B must have a net borrowing at 6.0%. See figure 1 below for swap arrangement.

5.3% 5.4%
5.0% L + 0.6%
Company A FI Company B

L L

Figure 1. Swap arrangement between Company A and B.

Problem 7.2
Company Y has higher rates of interest in both the Yen and the Dollars market because it has
a lower credit rating than Company X.
Company Y pays 1.5% more in Yen market, and 0.4% more in USD market than Company
X.

Therefore:
X has a comparative advantage in the Yen market. Thus, X will borrow in the Yen market at
5.0% pa
Y has a comparative advantage in the USD market. Thus, Y will borrow in the USD market
at 10% pa

They then use a currency swap to transform X’s loan into an USD loan and Y’s loan into a
Yen loan.

Total benefit to all parties = (6.5 - 5.0) - (10-9.6) = 1.1% pa

Since FI earns 0.5% pa, then Company X gains 0.3% pa and Company B also gains 0.3% pa.

This means the swaps should result in X having a net borrowing at 6.2% (=6.6% - 0.3%) pa
and,
Y must have a net borrowing at 9.3% (=9.6% - 0.3%) pa. See figure 1 below for swap
arrangement.

FI gains 1.2% pa from its contract with Y, while it loses 0.7% pa from its contract with X.
Thus having its expected gain of 0.5% (=1.2% - 0.7%). See figure 2 below for swap
arrangement

Yen 5.0% Yen 6.2%

Company X FI Company Y
USD 10.0%
Yen 5.0% USD 9.3% USD 10.0%

Figure 1. Swap arrangement between Company X and Y.

Problem 7.3
Value of the swap to party paying floating:
In 4 months it will receive: K= 0.5 x 0.07 x 100 m = $3.5 million
In 4 months it will pay: K* = 0.5 x 0.046 x 100 m = $2.3 million
L in four months’ time will be paid.

Vswap = Bfix - Bfl

n
Bfix = ∑ K e +Q e
−rt −r t n n

i=1

4 10
=3.5 e−(0.05)( 12 )+ 103.5 e−0.05( 12 )

=$102.718 million

Bfl = (Q+ K ¿¿ ¿) e−rt ¿

10
= (100 + 2.3¿ e−0.05 ( 12 )

= $100.609 million

Therefore:
Vswap = Bfix - Bfl = 102.718 – 100.609 = $2.109m for the company paying floating and,
Vswap = Bfl - Bfix = 100.609 – 102.718 = -$2.109m for the part paying fixed.
So, the party paying fixed rates loses out in the deal.

Problem 7.5
Sterling interest is exchanged at £2.0 million pa (=20 x 0.10)
Dollar interest is exchanged at $1.8 million pa (= 30 x 0.06)

Value of currency swap

Vswap= B$ – S0B£
S0 = 1.8500 $/£
 1 5
B$ = 1.8 e(−0.04 )( 4 )+(30+1.8)e(−0.04)( 4 )

= $32.031 million

1 5
B£ = 2 e(−0.07)( 4 ) +(20+2)e (−0.07)( 4 )

= £22.122 million

Therefore:
Value of swap to party paying sterling = 32.031 - 22.122 x 1.8500 = -8.894 million
Value of swap to party paying in dollars = 22.122 x 1.8500 - 32.031 = 8.894 million

Problem 7.9
Total apparent benefit to all parties = (8.8 – 8) - (L - L) = 0.8%
Since Bank nets 0.2% pa, X and Y will each net 0.3% pa.

This means the swap should result in X having a net return of 8.3% (=8.0% + 0.3%) pa and,
Y must have a net return of L + 0.3% pa. See figure 3 below for swap arrangement

8.3% 8.5%
L 8.8%
Company X B Company Y
L L

Figure 3. Swap arrangement between Company X and Y.

7.10.

At the end of year 3 the financial institution was due to receive $500,000 ( % of $10
million) and pay $450,000 ( % of $10 million). The immediate loss is therefore
$50,000. To value the remaining swap we assume than forward rates are realized. All forward
rates are 8% per annum. The remaining cash flows are therefore valued on the assumption
that the floating payment is and the net payment that
would be received is . The total cost of default is therefore the
cost of foregoing the following cash flows:

3 year: $50,000
3.5 year: $100,000
4 year: $100,000
4.5 year: $100,000
5 year: $100,000

Discounting these cash flows to year 3 at 4% per six months, we obtain the cost of the default
as $413,000.

7.12

When interest rates are compounded annually

where is the T-year forward rate, is the spot rate, is the domestic risk-free rate, and
is the foreign risk-free rate. As and , the spot and forward exchange
rates at the end of year 6 are

Spot: 0.8000
1 year forward: 0.8388
2 year forward: 0.8796
3 year forward: 0.9223
4 year forward: 0.9670

The value of the swap at the time of the default can be calculated on the assumption that
forward rates are realized. The cash flows lost as a result of the default are therefore as
follows:

Year Dollar Paid CHF Forward Dollar Equiv Cash Flow

Received Rate of CHF Lost
Received
6 560,000 300,000 0.8000 240,000 -320,000
7 560,000 300,000 0.8388 251,600 -308,400
8 560,000 300,000 0.8796 263,900 -296,100
9 560,000 300,000 0.9223 276,700 -283,300
10 7,560,000 10,300,000 0.9670 9,960,100 2,400,100

Discounting the numbers in the final column to the end of year 6 at 8% per annum, the cost of
the default is $679,800.

Chapter 13

13.1 To say that the temperature follows a Markov process means that only today’s
temperature is relevant for predicting the temperature at a future date. Therefore the
temperature observed in previous days would have no relevance. I don’t think that
temperature follows a Markov process because if for example it has been raining for the past
few days then you have to factor that in when you try to predict the probability of rain
tomorrow.
13.2 Given that all traders use the same set of information to make decisions, if there was an
observable trading rule that gives consistently above average returns then everyone else
would figure it out and those returns would be the new average.
13.3 Let the initial position=A
Then the cash position would follow a normal distribution with parameter (A+2, 16).
A +2
Pr [A<0) : -( ¿=0.05
4
A +2
From the stats tables - ( ¿=-1.64
4
Therefore A=$4 560 000.
13.4 (a) If there is no correlation between X 1 and X 2 , then they are independent of each other,

therefore:[ X ¿ ¿ 1+ X 2 ] ∅ ¿ [a 1+ µ1 T +a 2+ µ2 T , σ 1 T + σ 2 T ¿
2 2

∴ ∅ [a 1+ a2+( µ ¿ ¿ 1+µ 2)T ,(σ ¿¿ 2¿ ¿1+ σ 22) T ¿ ¿ ¿

(b) If there is a correlation ρ between the variables at any short time interval then;

Δt has the following distribution ; ∅ [( µ ¿ ¿ 1+ µ2 ) Δ t ,(σ ¿¿ 2¿¿ 1+ σ 2 +2 ρ σ 1 σ 2) Δt ¿¿ ¿

2

Finally ∅ [(µ ¿ ¿ 1+ µ2 )T ,(σ ¿¿ 2¿ ¿1+ σ 2+ 2 ρ σ 1 σ 2 )T ¿ ¿ ¿

2

13.5
The change in S during the first three years has the probability distribution

(2 3 9 3)  (6 27)

The change during the next three years has the probability distribution

(3 3 16 3)  (9 48)

The change during the six years is the sum of a variable with probability distribution (6 27)

and a variable with probability distribution(9 48) . The probability distribution of the
change is therefore
(6  9 27  48)

 (15 75)

Since the initial value of the variable is 5, the probability distribution of the value of the
variable at the end of year six is
 (20 75)
13.8
13.8
In:
SS tStμσ εΔ =Δ +Δ
the expected increase in the stock price and the variability of the stock price are constant
when both are expressed as a proportion (or as a percentage) of the stock price
In:
SttσεΔ = Δ +Δ
the expected increase in the stock price and the variability of the stock price are constant in
absolute terms. For example, if the expected growth rate is $5 per annum when the stock
price is $25, it is also $5 per annum when it is $100. If the standard deviation of weekly stock
price movements is $1 when the price is $25, it is also $1 when the price is $100.
In:
SS ttΔ =Δ +Δ
the expected increase in the stock price is a constant proportion of the stock price while the
variability is constant in absolute terms.
In:
StStΔ = Δ +Δ
the expected increase in the stock price is constant in absolute terms while the variability of
the proportional stock price change is constant.
The model:
SS tStΔ =Δ +Δ
is the most appropriate one since it is most realistic to assume that the expected percentage
return and the variability of the percentage return in a short interval are constant.