Attempt all questions.
Section-A
Question1) What are the most significant aspects of the design of a new futures contract? Describe how margins protect investors against possibility of default?
Question2) Desribe what is meant by a perfect hedge? Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain.
Question3) `What is the purpose of the convexity adjustment made to EuroDollar futures rates? Why is it essential?
Question4) Assume Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent annually against six-month Dollar LIBOR for Dollars and 11.25 - 11.65 percent annually against six-month Dollar LIBOR for British pound sterling. At what rates would Morgan Guaranty enter into a $/£ currency swap?
Section-B
Case Study: The Centralia Corporation’s Currency Swap
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct the wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in an European Union. Plant is expected to cost €5,500,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $2,900,000; the remainder of the plant would be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it will have to pay 7 percent per annum to borrow Euros, whereas the normal borrowing rate in the Euro zone for well-known firms of equivalent risk is 6 percent. Alternatively, Centralia could borrow Dollars in the U.S. at a rate of 8 percent.
Questions:
Question1) Assume a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it should pay a 9 percent fixed rate in the United States for Dollars, while it could borrow Euros at 6 percent. The exchange rate has been forecast to be $1.33/€1.00 in one year. Set up a currency swap that would benefit each counterparty.
Question2) Assume that one year after inception of the currency swap between Centralia and the Spanish MNC, the U.S. Dollar fixed-rate has fallen from 8 to 6 percent and the Euro zone fixed-rate for Euros has fallen from 6 to 5.50 percent. In both Dollars and Euros, find out the market value of the swap if the exchange rate is $1.3343/€1.00.