a) Describe the term “swap” and explain three main types of swaps which you came
ID: 2787871 • Letter: A
Question
a) Describe the term “swap” and explain three main types of swaps which you came across
in the course. (6 marks)
b) Your company is based in the USA and has an account payable of 100 million Euros
that is due in 3 month from now.
I. What is the risk exposure? (1 mark)
II. How would you hedge it with a future contract, assuming each contract size is
100,000 Euros? (3 marks)
c) GE stock is currently trading for $50 per share. A one-year European call option with a
strike price of $55 is currently trading for $8.00. If the one-year risk-free interest rate is
5 %, what is the value of a one-year European put option on GE with a strike price of
$55? (5 marks)
QUEST
Explanation / Answer
a.Swap is a derivative contract where two parties exchange financial instruments. Mostly swap involves cash flow based on notional principal amount that both the parties agreed to.Usually Notional principal does not exchange between the parties. Each cashflow comprises of one leg of the swap contract . One leg is generally fixed and other is variable. Swap can be used to hedge again certain risk such as Interest rate risk or to speculate on the changes in expected direction of underlying prices.Most of the swap are traded over the counter.
Different types of SWAP:
Interest rate swap:The most common type of Swap is interest rate swap(IRS).Mostly there are Fixed floating IRS agreed between counter parties. In this swap one party agreed to make payment to other based on initially agreed fixed rate of interest on Notional Principal and receive back payment based on Floating rate of interest.
Currency Swap:Currency swap involves exchanging Principals and fixed rate interest on a loan in one currency for principal and fixed rate interest payments on loan equivalent to another currency.
Equity Swap:Equity Swap is the derivative contract where a set future cashflows are exchanged between parties at set date in future.Cashflows are reffered as legs, where one leg is Equity index and the other leg is Floating rate Interest rate i.e., LIBOR
b. i. Risk exposure of US Company: US company faces the risk of rising the rate of Euro Currency.
ii. Company will enter into Futures contract to hedge against risk exposure, Company have to Buy EURO futures(F+) No of Contacts= Exposure/ lot size= 100000000/100000= 1000 contracts
c. PUT CALL PARITY:
P0+S0= C0+ PV of E
P0+50=8+(55/1.05)
P0= 52.38+8-50
P0 = $10.38
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