Question

(a) Imagine interest rates of US and UK are 10% and 12% respectively. Spot rate is $1.4700/1£. What is future price of a six months (180 days) Sterling pounds futures contract which is 100 days into the contract?

(b) Briefly explain how interest rate risk can be hedge through an interest rate swap.

(Please provide detailed answers)

Answer 1

a. Since 80 days are remaining on the contract, we will use the covered interest rate parity condition:

Future Price = 1.47 x (1.1/1.12)^(80/360) = $1.464126/ pound. This will be the future price.

b. Interest rate risk means the potential for investment losses that result from a change in interest rates. Hence, to hedge from interest rate risk, we can use an interest rate swap wherein we receive the fixed-rate and pay the floating rate. This will ensure that we get a fixed amount in interest in every period irrespective of how the interest rate moves.