Company X has entered into a 7-year currency swap with company Y. Under the term

Question

Company X has entered into a 7-year currency swap with company Y. Under the terms of the swap, company X receives a fixed interest payment at 3.2% per annum in Euros and pays interest at 7% per annum in US dollars. Interest payments are exchanged once a year. The relevant principal amounts are 10 million dollars and 9 million Euros. Suppose that company Y declares bankruptcy at the end of year 4, when the exchange rate is $1.17 per euro. What is the cost (lost profit) to the financial institution? Assume that, at the end of year 4, the interest rate is 3.2% per annum in Euros and 7% per annum in US dollars for all maturities. All interest rates are quoted with annual compounding.

Explanation / Answer

Time Floating rate Euro Floating cash Flow-Euro Fixed Cash Flow-$ Net Cash Flow 0 3.20% 0.5 3.20% 0.144 -0.7 0.844 1 3.20% 0.144 -0.7 0.844 1.5 3.20% 0.144 -0.7 0.844 2 3.20% 0.144 -0.7 0.844 2.5 3.20% 0.144 -0.7 0.844 3 3.20% 0.144 -0.7 0.844 3.5 3.20% 0.144 -0.7 0.844 Net Cash Flow at the end of the 4th Year 4 3.20% 0.144 -0.7 0.844 6.752 4.5 3.20% 0.144 -0.7 0.844 5 3.20% 0.144 -0.7 0.844 5.5 3.20% 0.144 -0.7 0.844 6 3.20% 0.144 -0.7 0.844 6.5 3.20% 0.144 -0.7 0.844 7 3.20% 0.144 -0.7 0.844 So at the end of the 4th Year the net cash flow is 6.752 The exchange rate at that time =$1.17 per Euro So the Profit should be 6.1752*1.17 $7.22 Million

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