Question

National Bank has a $200b of Adjustable Rate Mortgage (ARM) as assets on its balance sheet. The interest rate on the ARM is 3%+Libor. As a result, the bank will receive floating interest. The bank is considering hedging the risk in the interest income from the assets with a three-year interest rate swap. What should be the bank’s receipt and payment cash flows in the swap?

Select one:

a. The Bank should pay Libor and receive fixed interest rate.

b. The Bank should pay fixed and Libor fixed interest rate.

c. The Bank should pay Libor and receive Libor+3% interest rate.

d. The Bank should pay Libor and receive Libor interest rate.

e. The Bank should pay fixed and receive fixed interest rate.

The Utopian peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine peso was floated. In January 2003 it was trading at Ps1.50/$. During that one year period Utopia's inflation rate was 68% on an annualized basis. Inflation in the United States during that same period was 4.8% annualized. In January 2003, the peso is

Select one:

a. Under-valued by 6.9%

b. Under-valued by 6.4%

c. Over-valued by 6.9%

d. Under-valued by 37.6%

e. Over-valued by 37.6%

Current interest rates are i_$=4%;i_€=6%. Expected interest rates next year are: i_$=7%;i_€=3%. Expected spot rate in two years is S₂($/€)=1.09. Use the asset market approach to compute the current spot rate S0($/€). Please just type in the number without the currency signs. For example, if your answer is $1.25/€, then type in 1.25 as your final answer.  Please keep at least 2 decimal numbers (up to 5 decimal numbers). (This one is Free Response)

Answer 1

As the Bank is receiving floating interst, in the Swap it should pay the floating rate and receive fixed rate to hedge its risk. (option a is correct)

The currency of the country with higher inflation will be undervalued against the currency with lower inflation rate. As the inflation was higher in Peso by (1.68/1.048-1 = 60.31% , the Peso should have been devalued by 60.3% apx. However it was devalued by 50% (From 1Ps/$ to 1.5Ps/$) only . So, the Peso is still overvalued by 1.6031/1.5 = 1.0687 or 6.9% (option C is correct)