BUS322 TMA TMB TMD 2014 TUT05 CH08

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Problem 8.1 Amber McClain

Amber McClain, the currency speculator we met earlier in the chapter,sells eight June futures contracts for 500,000 pesos at the closing price quoted in Exhibit 8.1.

a. What is the value of her position at maturity if the ending spot rate is $0.12000/Ps?b. What is the value of her position at maturity if the ending spot rate is $0.09800/Ps?c. What is the value of her position at maturity if the ending spot rate is $0.11000/Ps?

a.b.c.AssumptionsValuesValuesValuesNumber of pesos per futures contract500,000500,000500,000Number of contracts8.008.008.00Buy or sell the peso futures?SellSellSell

Ending spot rate ($/peso)$0.12000$0.09800$0.11000June futures settle price from Exh8.1 ($/peso)$0.10773$0.10773$0.10773 Spot - Futures$0.01227($0.00973)$0.00227

Value of total position at maturity (US$)($49,080.00)$38,920.00($9,080.00) Value = - Notional x (Spot - Futures) x 8

InterpretationAmber buys at the spot price and sells at the futures price.If the futures price is greater than the ending spot price, she makes a profit.

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Problem 8.2 Peleh's Puts

Peleh writes a put option on Japanese yen with a strike price of $0.008000/ (125.00/$) at a premium of 0.0080 per yen and with an expiration date six months from now. The option is for 12,500,000. What is Peleh's profit or loss at maturity if the ending spot rates are 110/$, 115/$, 120/$, 125/$, 130/$, 135/$, and 140/$.

a)b)c)d)e)f)g)AssumptionsValuesValuesValuesValuesValuesValuesValuesNotional principal ()12,500,00012,500,00012,500,00012,500,00012,500,00012,500,00012,500,000Maturity (days)180180180180180180180Strike price (US$/)$0.008000$0.008000$0.008000$0.008000$0.008000$0.008000$0.008000Premium (US$/)$0.000080$0.000080$0.000080$0.000080$0.000080$0.000080$0.000080

Ending spot rate (/US$)110.00115.00120.00125.00130.00135.00140.00in US$/$0.009091$0.008696$0.008333$0.008000$0.007692$0.007407$0.007143

Gross profit on option$0.000000$0.000000$0.000000$0.000000$0.000308$0.000593$0.000857Less premium($0.000080)($0.000080)($0.000080)($0.000080)($0.000080)($0.000080)($0.000080)Net profit (US$/)($0.000080)($0.000080)($0.000080)($0.000080)$0.000228$0.000513$0.000777

Net profit, total($1,000.00)($1,000.00)($1,000.00)($1,000.00)$2,846.15$6,407.41$9,714.29

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Problem 8.3 Ventosa Investments

Jamie Rodriguez, a currency trader for Chicago-based Ventosa Investments, uses the following futures quotes on the British pound () to speculate on the value of the pound.

British Pound Futures, US$/pound (CME)Contract = 62,500 poundsOpenMaturityOpenHighLowSettleChangeHighInterestMarch1.42461.42681.42141.42280.00321.470025,605June1.41641.41881.41461.41620.00301.4550809

a. If Jaime buys 5 June pound futures, and the spot rate at maturity is $1.3980/, what is the value of her position?b. If Jamie sells 12 March pound futures, and the spot rate at maturity is $1.4560/, what is the value of her position?c. If Jamie buys 3 March pound futures, and the spot rate at maturity is $1.4560/, what is the value of her position?d. If Jamie sells 12 June pound futures, and the spot rate at maturity is $1.3980/, what is the value of her position?

a)b)c)d)AssumptionsValuesValuesValuesValuesPounds () per futures contract62,50062,50062,50062,500Maturity monthJuneMarchMarchJuneNumber of contracts512312Did she buy or sell the futures?buyssellsbuyssells

Ending spot rate ($/)$1.3980$1.4560$1.4560$1.3980Pound futures contract, settle price ($/)$1.4162$1.4228$1.4228$1.4162 Spot - Futures($0.0182)$0.0332$0.0332($0.0182)

Value of position at maturity ($)($5,687.50)($24,900.00)$6,225.00$13,650.00buys: Notional x (Spot - Futures) x contractssells: Notional x (Spot - Futures) x contracts

InterpretationBuys a future: Jamie buys at the futures price and sells at the ending spot price. She therefore profits when the futures price is less than the ending spot price.

Sells a future: Jamie buys at the ending spot price and sells at the futures price. She therefore profits when the futures price is greater than the ending spot price.

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Problem 8.4 Sallie Schnudel

Sallie Schnudel trades currencies for Keystone Funds in Jakarta. She focuses nearly all of her time and attention on the U.S. dollar/Singapore dollar ($/S$) cross-rate. The current spot rate is $0.6000/S$. After considerable study, she has concluded that the Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. She has the following options on the Singapore dollar to choose from:

OptionStrike PricePremiumPut on Sing $$0.6500/S$$0.00003/S$Call on Sing $$0.6500/S$$0.00046/S$

a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars?b. What is Sallie's breakeven price on the option purchased in part (a)?c. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.7000/S$?

d. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is $0.8000/S$?

Option choices on the Singapore dollar:Call on S$Put on S$Strike price (US$/Singapore dollar)$0.6500$0.6500Premium (US$/Singapore dollar)$0.00046$0.00003

AssumptionsValuesCurrent spot rate (US$/Singapore dollar)$0.6000Days to maturity90Expected spot rate in 90 days (US$/Singapore dollar)$0.7000

a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars?

Since Sallie expects the Singapore dollar to appreciate versus the US dollar, she should buy a call on Singapore dollars. This gives her the right to BUY Singapore dollars at a future date at $0.65 each, and then immediately resell them in the open market at $0.70 each for a profit. (If her expectation of the future spot rate proves correct.)

b. What is Sallie's breakeven price on the option purchased in part a)?Per S$Strike price$0.65000Note this does not include any interest cost on the premium.Plus premium$0.00046Breakeven$0.65046

c. What is Sallie's gross profit and net profit (including premium) if the ending spot rate is $0.70/S$?

Gross profitNet profit(US$/S$)(US$/S$)Spot rate$0.70000$0.70000Less strike price($0.65000)($0.65000)Less premium($0.00046)Profit$0.05000$0.04954

d. What is Sallie's gross profit and net profit (including premium) if the ending spot rate is $0.80/S$?

Gross profitNet profit(US$/S$)(US$/S$)Spot rate$0.80000$0.80000Less strike price($0.65000)($0.65000)Less premium($0.00046)Profit$0.15000$0.14954

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Problem 8.5 Blade Capital (A)

Christoph Hoffeman trades currency for Blade Capital of Geneva. Christoph has $10 million to begin with, and he must state all profits at the end of any speculation in U.S. dollars. The spot rate on the euro is $1.3358/, while the 30-day forward rate is $1.3350/.

a. If Christoph believes the euro will continue to rise in value against the U.S. dollar, so that he expects the spot rate to be $1.3600/ at the end of 30 days, what should he do?

b. If Christoph believes the euro will depreciate in value against the U.S. dollar, so that he expects the spot rate to be $1.2800/ at the end of 30 days, what should he do?

a.b.AssumptionsValuesValuesInitial investment (funds available)$10,000,000$10,000,000Current spot rate (US$/)$1.3358$1.335830-day forward rate (US$/)$1.3350$1.3350Expected spot rate in 30 days (US$/)$1.3600$1.2800

Strategy for Part a):One of the more interesting dimensions of speculating in the forward market is that if the speculator has access to the forward market (bank lines or relationships when working on behalf of an established firm), many forward speculation strategies require no actual cash flow position up front. In this case, Christoph believes the dollar will be trading at $1.36/ in the open market at the end of 30 days, but he has the ability to buy or sell dollars at a forward rate of $1.3350/. He should therefore buy euros forward 30 days (requires no actual cash flow up front), and at the end of 30 days take delivery of those euros and sell in the spot market at the higher dollar rate for profit.

Initial investment principle$10,000,000.0030 day forward rate (US$/)$1.3350Euros bought forward (Investment / forward rate) 7,490,636.70Spot rate in open market at end of 30 days (US$/)$1.3600US$ proceeds (euros bought forward exchanged to US$ spot)$10,187,265.92Profit in US$$187,265.92

Strategy for Part b):Again, a profitable strategy can be executed without any actual cash flow changing hands at the beginning of the period. Since Christoph believes that the dollar will strengthen to $1.28 in 30 days, he should sell euros forward now at the higher dollar rate, wait 30 days and buy the euros needed on the open market at $1.28, and immediately then use those euros to fulfill his forward contract to sell euros for dollars at $1.3350. For a profit.

Investment funds needed in 30 days$10,000,000.00Spot rate in open market at end of 30 days$1.2800Euros bought in open market in 30 days (Investment / spot rate) 7,812,500.00

Stefan had sold these euros forward at the start of the 30 day period.30 day forward rate (US$/)$1.3350US$ proceeds (euros sold forward into US$)$10,429,687.50Profit in US$$429,687.50

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Problem 8.6 Blade Capital (B)

Christoph Hoffeman of Blade Capital now believes the Swiss franc will appreciate versus the U.S. dollar in the coming three-month period. He has $100,000 to invest. The current spot rate is $0.5820/SF, the three-month forward rate is $0.5640/SF, and he expects the spot rates to reach $0.6250/SF in three months.

a. Calculate Christoph's expected profit assuming a pure spot market speculation strategy.b. Calculate Christoph's expected profit assuming he buys or sells SF three months forward.

a.b.AssumptionsValuesValuesInitial investment (funds available)$100,000$100,000Current spot rate (US$/Swiss franc)$0.5820$0.5820Six-month forward rate (US$/Swiss franc)$0.5640$0.5640Expected spot rate in six months (US$/Swiss franc)$0.6250$0.6250

Strategy for Part a:1. Use the $100,000 today to buy SF at spot rate171821.3058419242. Hold the SF indefinitely.3. At the end of six months, convert SF at expected rate$0.62504. Yielding expected dollar revenues of$107,388.325. Realize profit (revenues less $100,000 initial invest)$7,388.32

Strategy for Part b:1. Buy SF forward six months (no cash outlay required)2. Fulfill the six months forward in six months177304.964539007cost in US$($100,000.00)3. Convert the SF into US$ at expected spot rate$110,815.604. Realize profit$10,815.60

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Problem 8.7 Chavez S.A.

Chavez S.A., a Venezuelan company, wishes to borrow $8,000,000 for eight weeks. A rate of 6.250% per annum is quoted by potential lenders in New York, Great Britain, and Switzerland using, respectively, international, British, and the Swiss-Eurobond definitions of interest (day count conventions). From which source should Chavez borrow?

AssumptionsValuesPrincipal borrowing need$8,000,000Maturity needed, in weeks8Rate of interest charged by ALL potential lenders6.250%

New York interest rate practicesInterest calculation uses: Exact number of days in period56 Number of days in financial year360 So the interest charge on this principal is$77,777.78

Great Britain interest rate practicesInterest calculation uses: Exact number of days in period56 Number of days in financial year360 So the interest charge on this principal is$77,777.78

Swiss interest rate practicesInterest calculation uses: Assumed 30 days per month for two months60 Number of days in financial year360 So the interest charge on this principal is$83,333.33

Andina should borrow in Great Britain because it has the lowest interest cost.

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Problem 8.8 Botany Bay Corporation

Botany Bay Corporation of Australia seeks to borrow US$30,000,000 in the Eurodollar market. Funding is needed for two years. Investigation leads to three possibilities. Compare the alternatives and make a recommendation.

#1. Botany Bay could borrow the US$30,000,000 for two years at a fixed 5% rate of interest#2. Botany Bay could borrow the US$30,000,000 at LIBOR + 1.5%. LIBOR is currently 3.5%, and the rate would be reset every six months

#3. Botany Bay could borrow the US$30,000,000 for one year only at 4.5%. At the end of the first year Botany Bay would have to negotiate for a new one-year loan.

AssumptionsValuesPrincipal borrowing need$30,000,000Maturity needed, in years2.00Fixed rate, 2 years5.000%Floating rate, six-month LIBOR + spread Current six-month LIBOR3.500% Spread1.500%Fixed rate, 1 year, then re-fund4.500%

First 6-monthsSecond 6-monthsThird 6-monthsFourth 6-months#1: Fixed rate, 2 yearsInterest cost per year$1,500,000$1,500,000 Certainty over access to capitalCertainCertainCertainCertain Certainty over cost of capitalCertainCertainCertainCertain

#2: Floating rate, six-month LIBOR + spreadInterest cost per year$750,000$750,000$750,000$750,000 Certainty over access to capitalCertainCertainCertainCertain Certainty over cost of capitalCertainUncertainUncertainUncertain

#3: Fixed rate, 1 year, then re-fundInterest cost per year$1,350,000?????? Certainty over access to capitalCertainCertainUncertainUncertain Certainty over cost of capitalCertainCertainUncertainUncertain

Only alternative #1 has a certain access and cost of capital for the full 2 year period.Alternative #2 has certain access to capital for both years, but the interest costs in the final 3 of 4 periods is uncertain.Alternatvie #3, possessing a lower interest cost in year 1, has no guaranteed access to capital in the second year. Depending on the company's business needs and tolerance for interest rate risk, it could choose between #1 and #2.

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Problem 8.9 Vatic Capital

Cachita Haynes works as a currency speculator for Vatic Capital of Los Angeles. Her latest speculative position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is 120.00/$. She must choose between the following 90-day options on the Japanese yen:

OptionStrike PricePremiumPut on yen125/$$0.00003/S$Call on yen125/$$0.00046/S$

a. Should Cachita buy a put on yen or a call on yen?b. What is Cachita's breakeven price on the option purchased in part (a)?c. Using your answer from part (a), what is Cachita's gross profit and net profit (including premium) if the spot rate at the end of 90 days is 140/$?

AssumptionsValuesCurrent spot rate (Japanese yen/US$)120.00 in US$/yen$0.00833Maturity of option (days)90Expected ending spot rate in 90 days (yen/$)140.00 in US$/yen$0.00714

Call on yenPut on yenStrike price (yen/US$)125.00125.00 in US$/yen$0.00800$0.00800Premium (US$/yen)$0.00046$0.00003

a. Should she buy a call on yen or a put on yen? Cachita should buy a put on yen to profit from the rise of the dollar (the fall of the yen).

b. What is Cachita's break even price on her option of choice in part a)? Cachita buys a put on yen. Pays premium today. In 90 days, exercises the put, receiving US$.in yen/$Strike price$0.00800125.00Less premium-$0.00003Breakeven$0.00797125.47

c. What is Cachita's gross profit and net profit if the end spot rate is 140 yen/$?

Gross profitNet profit(US$/yen)(US$/yen)Strike price$0.00800$0.00800Less spot rate-$0.00714-$0.00714Less premium-$0.00003Profit$0.00086$0.00083

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Problem 8.10 Calling All Profits

Assume a call option on euros is written with a strike price of $1.2500/ at a premium of 3.80 per euro ($0.0380/) and with an expiration date three months from now. The option is for 100,000. Calculate your profit or loss should you exercise before maturity at a time when the euro is traded spot at .....

Note: the option premium is 3.8 cents per euro, not 38 cents per euro.

a.b.c.d.e.f.g.AssumptionsValuesValuesValuesValuesValuesValuesValuesNotional principal (euros) 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00Maturity (days)90909090909090Strike price (US$/euro)$1.2500$1.2500$1.2500$1.2500$1.2500$1.2500$1.2500Premium (US$/euro)$0.0380$0.0380$0.0380$0.0380$0.0380$0.0380$0.0380Ending spot rate (US$/euro)$1.1000$1.1500$1.2000$1.2500$1.3000$1.3500$1.4000

Gross profit on option$0.0000$0.0000$0.0000$0.0000$0.0500$0.1000$0.1500Less premium($0.0380)($0.0380)($0.0380)($0.0380)($0.0380)($0.0380)($0.0380)Net profit (US$/euro)($0.0380)($0.0380)($0.0380)($0.0380)$0.0120$0.0620$0.1120

Net profit, total($3,800.00)($3,800.00)($3,800.00)($3,800.00)$1,200.00$6,200.00$11,200.00

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Problem 8.11 Mystery at Baker Street

Arthur Doyle is a currency trader for Baker Street, a private investment house in London. Baker Streets clients are a collection of wealthy private investors who, with a minimum stake of 250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.

Arthur is convinced that the British pound will slide significantly -- possibly to $1.3200/ -- in the coming 30 to 60 days. The current spot rate is $1.4260/. Arthur wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the following put options would you recommend he purchase? Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense.

Strike PriceMaturityPremium$1.36/30 days$0.00081/$1.34/30 days$0.00021/$1.32/30 days$0.00004/$1.36/60 days$0.00333/$1.34/60 days$0.00150/$1.32/60 days$0.00060/

AssumptionsValuesCurrent spot rate (US$/)$1.4260Expected endings spot rate in 30 to 60 days (US$/)$1.3200Potential investment principal per person ()250,000.00

Put options on poundsPut #1Put #2Put #3Strike price (US$/)$1.36$1.34$1.32Maturity (days)303030Premium (US$/)$0.0008$0.0002$0.0000

Put options on poundsPut #4Put #5Put #6Strike price (US$/)$1.36$1.34$1.32Maturity (days)606060Premium (US$/)$0.0033$0.0015$0.0006

Issues for Sydney to consider:

1. Because his expectation is for "30 to 60 days" he should confine his choices to the 60 day options to be sure and capture the timing of the exchange rate change. (We have no explicit idea of why he believes this specific timing.)

2. The choice of which strike price is an interesting debate. * The lower the strike price (1.34 or 1.32), the cheaper the option price. * The reason they are cheaper is that, statistically speaking, they are increasingly less likely to end up in the money. * The choice, given that all the options are relatively "cheap," is to pick the strike price which will yield the required return. * The $1.32 strike price is too far 'down,' given that Sydney only expects the pound to fall to about $1.32.

Put #4Put #5Put #6Net profitNet profitNet profitStrike price$1.36000$1.34000$1.32000Less expected spot rate(1.32000)(1.32000)(1.32000)Less premium(0.00333)(0.00150)(0.00060)Profit$0.03667$0.01850($0.00060)

If Sydney invested an individual's principal purely in this specific option, they would purchase an option of the following notional principal ():75,075,075.08166,666,666.67416,666,666.67

Expected profit, in total (profit rate x notional):$2,753,003.00$3,083,333.33-$250,000.00Initial investment at current spot rate$356,500.00$356,500.00$356,500.00Return on Investment (ROI)772%865%-70%Risk: They could lose it all (full premium)

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Problem 8.12 Contrarious Calandra

Calandra Panagakos works for CIBC Currency Funds in Toronto. Calandra is something of a contrarian -- as opposed to most of the forecasts, she believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Calandra may choose between the following options on

the Canadian dollar:OptionStrike PricePremiumPut on C$$0.7000$0.00003/S$Call on C$$0.7000$0.00049/S$

a. Should Calandra buy a put on Canadian dollars or a call on Canadian dollars?b. What is Calandra's breakeven price on the option purchased in part (a)?c. Using your answer from part (a), what is Calandra's gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.7600?

d. Using your answer from part (a), what is Calandra's gross profit and net profit (including premium) if the spot rate at the end of 90 days is $0.8250?

AssumptionsValuesCurrent spot rate (US$/Canadian dollar)$0.6750Days to maturity90

Option choices on the Canadian dollar:Call optionPut option Strike price (US$/Canadian dollar)$0.7000$0.7000 Premium (US$/Canadian dollar)$0.00049$0.0003

a) Which option should Calandra buy?

Since Giri expects the Canadian dollar to appreciate versus the US dollar, he should buy a call on Canadian dollars.

b) What is Calandra's breakeven price on the option purchased in part a)?

Strike price$0.7000Plus premium0.00049Breakeven$0.7005

c) What is Calandra's gross profit and net profit (including premium) if the ending spot rate is $0.7600/C$?

Gross profitNet profit(US$/C$)(US$/C$)Spot rate$0.7600$0.7600Less strike price(0.7000)(0.7000)Less premium(0.00049)Profit$0.0600$0.05951

d) What is Calandra's gross profit and net profit (including premium) if the ending spot rate is $0.8250/C$?

Gross profitNet profit(US$/C$)(US$/C$)Spot rate$0.8250$0.8250Less strike price(0.7000)(0.7000)Less premium(0.00049)Profit$0.1250$0.12451

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Problem 8.13 Raid Gauloises

Raid Gauloises is a rapidly growing French sporting goods and adventure racing outfitter. The company has decided to borrow 20,000,000 via a euro-euro floating rate loan for four years. Raid must decide between two competing loan offerings from two of its banks.

Banque de Paris has offered the four-year debt at euro-LIBOR + 2.00% with an up-front initiation fee of 1.8%. Banque de Sorbonne, however, has offered euro-LIBOR + 2.5%, a higher spread, but with no loan initiation fees up-front, for the same term and principal. Both banks reset the interest rate at the end of each year.

Euro-LIBOR is currently 4.00%. Raids economist forecasts that LIBOR will rise by 0.5 percentage points each year. Banque de Sorbonne, however, officially forecasts euro-LIBOR to begin trending upward at the rate of 0.25 percentage points per year. Raid Gauloisess cost of capital is 11%. Which loan proposal do you recommend for Raid Gauloises?

Expected ChgAssumptionsValuesin LIBORPrincipal borrowing need 20,000,000Maturity needed, in years4.00Current euro-LIBOR4.000%Banque de Paris' spread & expectation2.000%0.500%Banque de Paris' initiation fee1.800%Banque de Sorbonne's spread & expectation2.500%0.250%Banque de Sorbonne's initiation fee0.000%

Raid Gauloises must evaluate both loan proposals under both potential interest rate scenarios.

Banque de Paris Loan ProposalYear 0Year 1Year 2Year 3Year 4Expected interest rates & payments: Expected euro-LIBOR4.000%4.500%5.000%5.500%6.000% Bank spread2.000%2.000%2.000%2.000%2.000% Interest rate6.000%6.500%7.000%7.500%8.000%

Funds raised, net of fees 19,640,000Expected interest costs- 1,300,000- 1,400,000- 1,500,000- 1,600,000Repayment of principal- 20,000,000 Total cash flows 19,640,000- 1,300,000- 1,400,000- 1,500,000- 21,600,000

All-in-cost of funds if: euro-LIBOR rises 0.500% per year7.7438% euro-LIBOR rises 0.250% per year7.1365% Found by plugging in .250% in expectations above.

Banque de Sorbonne Loan ProposalYear 0Year 1Year 2Year 3Year 4Expected interest rates & payments: Expected euro-LIBOR4.000%4.250%4.500%4.750%5.000% Bank spread2.500%2.500%2.500%2.500%2.500% Interest rate6.500%6.750%7.000%7.250%7.500%

Funds raised, net of fees 20,000,000Expected interest costs- 1,350,000- 1,400,000- 1,450,000- 1,500,000Repayment of principal- 20,000,000 Total cash flows 20,000,000- 1,350,000- 1,400,000- 1,450,000- 21,500,000

All-in-cost of funds if: euro-LIBOR rises 0.500% per year7.0370% Found by plugging in .500% in expectations above. euro-LIBOR rises 0.250% per year7.1036%

The Banque de Sorbonne loan proposal is actually lower all-in-cost under either interest rate scenario.

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Problem 8.14 Schifano Motors

Schifano Motors of Italy recently took out a 4-year 5 million loan on a floating rate basis. It is now worried, however, about rising interest costs. Although it had initially believed interest rates in the Euro-zone would be trending downward when taking out the loan, recent economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will slow monetary growth driving interest rates up.

Schifano is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering a Forward Rate Agreement (FRA) with an insurance company. According to the agreement, Schifano would pay to the insurance company at the end of each year the difference between its initial interest cost at LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in LIBOR. Conversely, the insurance company would pay to Schifano 70% of the difference between Schifanos initial interest cost and any increase in interest costs caused by a rise in LIBOR.

Purchase of the floating Rate Agreement will cost 100,000, paid at the time of the initial loan. What are Schifanos annual financing costs now if LIBOR rises and if LIBOR falls.? Schifano uses 12% as its weighted average cost of capital. Do you recommend that Schifano purchase the FRA?

AssumptionsValuesPrincipal borrowing need 5,000,000Maturity needed, in years4.00Current LIBOR4.000%Felini's bank spread2.500%Proportion of differential paid by FRA70%Cost of FRA 100,000

If LIBOR Falls 50 Basis Pts Per YearYear 0Year 1Year 2Year 3Year 4

Expected annual change in LIBOR-0.500%

LIBOR4.000%3.500%3.000%2.500%2.000% Bank spread2.500%2.500%2.500%2.500%2.500% Interest rate6.500%6.000%5.500%5.000%4.500%

Funds raised, net of fees 5,000,000Expected interest (interest rate x principal)- 300,000- 275,000- 250,000- 225,000Forward Rate Agreement- 100,000- 25,000- 50,000- 75,000- 100,000Repayment of principal- 5,000,000 Total cash flows 4,900,000- 325,000- 325,000- 325,000- 5,325,000

All-in-cost of funds (IRR)7.092%

If LIBOR Rises 50 Basis Pts Per YearYear 0Year 1Year 2Year 3Year 4

Expected annual change in LIBOR0.500%

LIBOR4.000%4.500%5.000%5.500%6.000% Bank spread2.500%2.500%2.500%2.500%2.500% Interest rate6.500%7.000%7.500%8.000%8.500%

Funds raised, net of fees 5,000,000Expected interest (interest rate x principal)- 350,000- 375,000- 400,000- 425,000Forward Rate Agreement- 100,000 17,500 35,000 52,500 70,000Repayment of principal- 5,000,000 Total cash flows 4,900,000- 332,500- 340,000- 347,500- 5,355,000

All-in-cost of funds (IRR)7.458%

This rather unusual forward rate agreement is somewhat one-sided in the favor of the insurance company. When Schifano is correct, Schifano pays the full difference in rates to the insurance company. But when interest rates move against Schifano, the insurance company pays Schifano only 70% of the difference in rates. And all of that is after Schifano paid 100,000 up-front for the agreement regardless of outcome. Not a very good deal.

A final note of significance is that since Schifano receives only 70% of the difference in rates, its total cost of funds is not effectively "capped"; they could in fact rise with no limit over the period as interest rates rose.

Pbm8.15

Problem 8.15 Chrysler LLC

Chrysler LLC, the now privately held company sold-off by DaimlerChrysler, must pay floating rate interest three months from now. It wants to lock in these interest payments by buying an interest rate futures contract. Interest rate futures for three months from now settled at 93.07, for a yield of 6.93% per annum.

a. If the floating-rate interest three months from now is 6.00%, what did Chrysler gain or lose? b. If the floating-rate interest three months from now is 8.00% , what did Chrysler gain or lose?

AssumptionsValuesInterest rate futures, closing price93.07Effective yield on interest rate futures6.930%

Three Months From NowFloating Rate isFloating Rate isChrysler's interest rate payments with futures6.000%8.000%

Interest payment due in three months6.000%8.000%Sell a future (take a short position)-6.930%-6.930% Gain or loss on position-0.930%1.070%LossGain

Pbm8.16

Problem 8.16 CB Solutions

Heather O'Reilly, the treasurer of CB Solutions, believes interest rates are going to rise, so she wants to swap her future floating rate interest payments for fixed rates. At present she is paying LIBOR + 2% per annum on $5,000,000 of debt for the next two years, with payments due semiannually. LIBOR is currently 4.00% per annum. Heather has just made an interest payment today, so the next payment is due six months from today.

Heather finds that she can swap her current floating rate payments for fixed payments of 7.00% per annum. (CB Solutions's weighted average cost of capital is 12%, which Heather calculates to be 6% per six month period, compounded semiannually).

a. If LIBOR rises at the rate of 50 basis points per six month period, starting tomorrow, how much does Heather save or cost her company by making this swap?

b. If LIBOR falls at the rate of 25 basis points per six month period, starting tomorrow, how much does Heather save or cost her company by making this swap?

AssumptionsValuesNotional principal$5,000,000LIBOR, per annum4.000%Spread paid over LIBOR, per annum2.000%Swap rate, to pay fixed, per annum7.000%

First SecondThirdFourthInterest & Swap Payments6-months6-months6-months6-months

a. LIBOR increases 50 basis pts/6 months0.500% Expected LIBOR4.500%5.000%5.500%6.000%

Current loan agreement: Expected LIBOR (for 6 months)-2.250%-2.500%-2.750%-3.000% Spread (for 6 months)-1.000%-1.000%-1.000%-1.000% Expected interest payment-3.250%-3.500%-3.750%-4.000%

Swap Agreement: Pay fixed (for 6-months)-3.500%-3.500%-3.500%-3.500% Receive floating (LIBOR for 6 months)2.250%2.500%2.750%3.000%

Net interest (loan + swap)-4.500%-4.500%-4.500%-4.500%

Swap savings? Net interest after swap$(225,000)$(225,000)$(225,000)$(225,000) Loan agreement interest(162,500)(175,000)(187,500)(200,000) Swap savings (swap cost)$(62,500)$(50,000)$(37,500)$(25,000)

b. LIBOR decreases 25 basis pts/6 months-0.250% Expected LIBOR3.750%3.500%3.250%3.000%

Current loan agreement: Expected LIBOR (for 6 months)-1.875%-1.750%-1.625%-1.500% Spread (for 6 months)-1.000%-1.000%-1.000%-1.000% Expected interest payment-2.875%-2.750%-2.625%-2.500%

Swap Agreement: Pay fixed (for 6-months)-3.500%-3.500%-3.500%-3.500% Receive floating (LIBOR for 6 months)1.875%1.750%1.625%1.500%

Net interest (loan + swap)-4.500%-4.500%-4.500%-4.500%

Swap savings? Net interest after swap$(225,000)$(225,000)$(225,000)$(225,000) Loan agreement interest(143,750)(137,500)(131,250)(125,000) Swap savings (swap cost)$(81,250)$(87,500)$(93,750)$(100,000)

In both cases CB Solutions is suffering higher total interest costs as a result of the swap.

Pbm8.17

Problem 8.17 Lluvia and Paraguas

Lluvia Manufacturing and Paraguas Products both seek funding at the lowest possible cost. Lluvia would prefer the flexibility of floating rate borrowing, while Paraguas wants the security of fixed rate borrowing. Lluvia is the more credit-worthy company. They face the following rate structure. Lluvia, with the better credit rating, has lower borrowing costs in both types of borrowing.

Lluvia wants floating rate debt, so it could borrow at LIBOR+1%. However it could borrow fixed at 8% and swap for floating rate debt. Paraguas wants fixed rate, so it could borrow fixed at 12%. However it could borrow floating at LIBOR+2% and swap for fixed rate debt. What should they do?

AssumptionsXavierZuluCredit ratingAAABBBPrefers to borrowFloatingFixedFixed-rate cost of borrowing8.000%12.000%Floating-rate cost of borrowing: LIBOR (value is unimportant)5.000%5.000% Spread1.000%2.000% Total floating-rate6.000%7.000%

Comparative Advantage in BorrowingValuesLluvia's absolute advantage: in fixed rate borrowing4.000% in floating-rate borrowing1.000%Comparative advantage in fixed rate 3.000%

One PossibilityXavierZuluLluvia borrows fixed-8.000%---Paraguas borrows floating----7.000%Lluvia pays Paraguas floating (LIBOR)-5.000%5.000%Paraguas pays Lluvia fixed 8.500%-8.500% Net interest after swap-4.500%-10.500%

Savings (own borrowing versus net swap): If Lluvia borrowed floating6.000% If Lluvia borrows fixed & swaps with Paraguas4.500%1.500%

If Paraguas borrows fixed12.000% If Paraguas borrows floating & swaps with Lluvia10.500%1.500%

The 3.0% comparative advantage enjoyed by Lluvia represents the opportunity set for improvement for both parties. This could be a 1.5% savings for each (as in the example shown) or any other combination which distributes the 3.0% between the two parties.

Pbm8.18

Problem 8.18 Trident's Cross Currency Swap: Sfr for US$

Trident Corporation entered into a three-year cross currency interest rate swap to receive U.S. dollars and pay Swiss francs. Trident, however, decided to unwind the swap after one year thereby having two years left on the settlement costs of unwinding the swap after one year. Repeat the calculations for unwinding, but assume that the following rates now apply:

AssumptionsValuesSwap Rates3- year bid3-year askNotional principal$10,000,000Original: US dollar5.56%5.59%Original spot exchange rate, SFr./$1.5000Original: Swiss franc1.93%2.01%New (1-year later) spot exchange rate, SFr./$1.5560New fixed US dollar interest5.20%New fixed Swiss franc interest2.20%

a. Interest & Swap PaymentsYear 0Year 1Year 2Year 3

Receive fixed rate dollars at this rate:5.56%5.56%5.56%On a notional principal of:$10,000,000Trident will receive cash flows:$556,000$556,000$10,556,000Exchange rate, time of swap (SFr./$)1.5000Trident will pay cash flows:30150030150015301500On a notional principal of:15000000Pay fixed rate Swiss francs at this rate:2.01%2.01%2.01%

b. Unwinding the swap after one-yearYear 1Year 2Year 3

Remaining dollar cash inflows$556,000$10,556,000PV factor at now current fixed $ interest5.20%0.95060.9036PV of remaining dollar cash inflows$528,517$9,538,232 Cumulative PV of dollar cash inflows$10,066,750

Remaining Swiss franc cash outflows30150015301500PV factor at now current fixed SF interest2.20%0.97850.9574PV of remaining SF cash outflows29501014649818 Cumulative PV of SF cash outflows14944827New current spot rate, SFr./$1.5560 Cumulative PF of SF cash outflows in $$9,604,645

Settlement: Cash inflow$10,066,750 Cash outflow(9,604,645) Net cash settlement of unwinding$462,105This is a cash receipt by Trident from the swap dealer.

Pbm8.19

Problem 8.19 Trident's Cross Currency Swap: Yen for Euros

Using the table of swap rates in the chapter (Exhibit 8.13), and assume Trident enters into a swap agreement to receive euros and pay Japanese yen, on a notional principal of 5,000,000. The spot exchange rate at the time of the swap is 104/.

a. Calculate all principal and interest payments, in both euros and Swiss francs, for the life of the swap agreement.

b. Assume that one year into the swap agreement Trident decides it wishes to unwind the swap agreement and settle it in euros. Assuming that a two-year fixed rate of interest on the Japanese yen is now 0.80%, and a two-year fixed rate of interest on the euro is now 3.60%, and the spot rate of exchange is now 114/, what is the net present value of the swap agreement? Who pays whom what?

AssumptionsValuesSwap Rates3- year bid3-year askNotional principal 5,000,000Euros -- 3.24%3.28%Spot exchange rate, Yen/euro104.00Japanese yen0.56%0.59%

a) Interest & Swap PaymentsYear 0Year 1Year 2Year 3

Receive fixed rate euros at this rate:3.24%3.24%3.24%On a notional principal of: 5,000,000Trident will receive cash flows: 162,000 162,000 5,162,000Exchange rate, time of swap (/)104.00Trident will pay cash flows:3,068,0003,068,000523,068,000On a notional principal of (yen):520,000,000Pay fixed rate Japanese yen at this rate:0.59%0.59%0.59%

b) Unwinding the swap after one-yearYear 1Year 2Year 3

Remaining euro cash inflows 162,000 5,162,000PV factor at now current fixed interest3.60%0.96530.9317PV of remaining cash inflows 156,371 4,809,484 Cumulative PV of cash infllows 4,965,855

Remaining cash outflows3068000523068000PV factor at now current fixed interest0.80%0.99210.9842PV of remaining cash outflows3043651514798280 Cumulative PV of cash outflows517,841,931New current spot rate, /114.00 Cumulative PV of cash outflows in 4,542,473

Settlement: Cash inflow 4,965,855 Cash outflow(4,542,473) Net cash settlement of unwinding 423,382This is a cash receipt by Trident from the swap dealer.

Pbm8.20

Problem 8.20 Falcor

Falcor is the U.S.-based automotive parts supplier which was spun-off from General Motors in 2000. With annual sales of over $26 billion, the company has expanded its markets far beyond the traditional automobile manufacturers in the pursuit of a more diversified sales base. As part of the general diversification effort, the company wishes to diversify the currency of denomination of its debt portfolio as well. Assume Falcor enters into a $50 million 7-year cross currency interest rate swap to do just that pay euro and receive dollars. Using the data in Exhibit 8.13, solve the following:

a. Calculate all principal and interest payments in both currencies for the life of the swap.

b. Assume that three years later Falcor decides to unwind the swap agreement. If 4-year fixed rates of interest in euros have now risen to 5.35% and 4-year fixed rate dollars have fallen to 4.40%, and the current spot exchange rate of $1.02/, what is the net present value of the swap agreement? Who pays who mwhat?

AssumptionsValuesSwap Rates7- year bid7-year askNotional principal$50,000,000US dollar5.86%5.89%Spot exchange rate, $/1.16Euros4.01%4.05%

a. Interest & Swap PaymentsYear 0Year 1Year 2Year 3Year 4Year 5Year 6Year 7

Receive fixed rate dollars at rate:5.86%Notional principal of:$50,000,000Receive cash inflows of:$2,930,000$2,930,000$2,930,000$2,930,000$2,930,000$2,930,000$52,930,000Spot exchange rate, $/1.16Pay cash outflows of: 1,745,690 1,745,690 1,745,690 1,745,690 1,745,690 1,745,690 44,849,138Notional principal of: 43,103,448Pay fixed rate euros at rate:4.05%

b. Unwindingthe SwapYear 0Year 1Year 2Year 3Year 4Year 5Year 6Year 7

If the swap is unwound three years later, there are four years of cash flows remaining:

Remaining dollar cash inflows$2,930,000$2,930,000$2,930,000$52,930,000PV factor at now current fixed $ interest4.40%0.95790.91750.87880.8418PV of remaining dollar cash inflows$2,806,513$2,688,231$2,574,934$44,555,354 Cumulative PV of $ cash infllows$52,625,033

Remaining euro cash outflows 1,745,690 1,745,690 1,745,690 44,849,138PV factor at now current fixed interest5.35%0.94920.90100.85530.8118PV of remaining euro cash outflows 1,657,038 1,572,889 1,493,012 36,409,603 Cumulative PV of cash outflows 41,132,542Spot exchange rate at unwinding ($/)1.02 Cumulative PV of cash outflows, $$41,955,193

Settlement: Cash inflow$52,625,033 Cash outflow(41,955,193) Net cash settlement of unwinding$10,669,840This is a net cash payment to Falcor from the swap dealer.