Question #55

of 77 The price of a forward contract: A) is equal to the value of the contract in equilibrium. B) is the settlement price for the underlying asset. C) must be equal to the market price at contract termination. Abel Smith works in the Treasury Department of OTS Ltd. OTS is an international construction firm, based in the United States. OTS hopes to raise €100 million through the issuance of a €100 million one-year fixed rate bond but is concerned about the currency risk exposure. TNA Bank proposed a one year EUR-USD currency swap with semi-annual settlements to OTS to mitigate the exchange rate risk. The notional principal would be €100 million. The bank provides the following information: Exhibit 1: MRR Spot Rate (annualized) Days $ MRR PV Factors Days MRR PV Factors 180 0.70% 0.9965 180 1.50% 0.9926 360 1.00% 0.9901 360 2.00% 0.9804 Using the information in Exhibit 1, the bank calculates that the currency swap's fixed rates are 0.85% on the USD and 1.75% on the euro. The term structure of MRR and MRR spot rates three months after the swap initiation is shown in Exhibit 2: Exhibit 2: MRR Spot Rate (annualized) Days $ MRR PV Factors Days MRR PV Factors 90 0.85% 0.9979 90 1.30% 0.9968 270 1.20% 0.9911 270 2.30% 0.9830 Exhibit 3: Exchange Rates Time Exchange Rate Time Exchange Rate Swap initiation 90 days after swap initiation €1: USD1.43 €1: USD1.48 1st settlement date 2nd settlement date €1: USD1.55 €1: USD1.55 OTS has an investment portfolio with similar weighting as the S&P500. Smith believes that the U.S. equity market could suffer further declines and OTS could hedge the equity risk using an equity swap. Smith obtained the outlook of the U.S. equity market in Exhibit 4. Exhibit 4: Performance of S&P500 for the Next Three Quarters Time S&P Index Level Swap initiation 1,190 1st quarter 1,000 2nd quarter 980 3rd quarter 1,050 4th quarter 1,130 Smith is proposing for OTS to be the party paying the equity return on a USD500 million one- year equity swap. OTS will be receiving fixed rate of 1% on a semi-annual basis. Smith makes two comments: Comment 1: A fixed-rate payer in an equity swap would not have to pay more than the fixed rate each period. Comment 2: Compared to an interest rate swap, the first payment in an equity swap will not be known at initiation.