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.

Answer 1

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