Finance Assignment: Derivatives, Treasury and Risk Management

This assignment solution delves into the realm of derivatives, focusing on treasury and risk management. It begins by examining interest rate parity using spot and forward rates, conducting covered interest arbitrage, and calculating the parity forward rate. The solution then moves on to interest rate swaps, calculating cost savings for two companies, constructing a swap diagram, determining effective fixed rates, and analyzing cash flows. It also explores the advantages and disadvantages of interest rate swaps, highlighting the risks involved, such as counterparty and credit risks, and the role of swaps as hedging tools. The assignment concludes with a discussion on the significance of derivatives in managing financial risks and the importance of mitigating risks in the over-the-counter market.

Running head: TREASURY AND RISK MANAGEMENT
Treasury and Risk Management
Name of the Student:
Name of the University:
Author’s Note:

1DERIVATIVES
Table of Contents
Question 1........................................................................................................................................2
Question 2........................................................................................................................................3
References........................................................................................................................................6

2DERIVATIVES
Question 1
a) Forward Rate using Interest Rate Parity:
Spot Rate: (1.255+1.260)/2: 1.258
Forward Rate: ((1.230+1.2450)/2): 1.238
US Int Rate: 3% UK Int Rate: 5%
Forward Rate: Spot Rate: 1.258*(1+3%/1+5%)
Forward Rate: 1.2340
b) Arbitrage Method
Initial Sum from £ £ 100,000
Convert Sum by using USD Spot Spot Rate 1.2575
USD Conversed Amount £ 125,750
Interest Rate in US 3.00%
USD Value after 3 Months $ 126,682.7
Convert the USD into £ £ 102,369.86
Less: Pay Interest on £ 3.00%
Amount Borrowed £ 100,000
Interest Amount £ 750
Gross Amount Earned in £ £ 101,619.86
Less: Borrowed Amount £ 100,000.00
Net Amount Earned £ 1,619.86
c) The forward rate used in Part A has been done using Interest Rate Parity while on the other
hand in order to well derive or estimate the forward rate the current 3 month forward rate for the
contract was considered.

3DERIVATIVES
Question 2
If both the parties that is XX and YY have well agreed that the swap interest rate P% (per half
year basis) against the LIBOR Rate is well fair, then this would mean that the payment of interest
rate between the XX and YY should be well equal. Here the XX would be borrowing at a
Floating rate from Bank A and Yy to borrow at a fixed rate basis from Bank B on an semi-annual
basis.
a) Cost Saving Calculations
 Company XX: Fixed Rate: 8%
 Floating Rate: Libor (7%)+0.24% (Basis Point)+0.40%(Bid-Ask Spread): 7.64%.
 Company Y: Fixed Rate: 6.6%
 Floating Rate: Libor (7%)+0.20% (Basis Point)+0.60%(Bid-Ask Spread): 7.80%.
 Total Cost Savings: Difference in Floating + Difference in Fixed Rate
 Fixed Rate Difference: 8%-6.6%: 1.40%
 Floating Rate Difference: 7.80%-7.64%: 0.16%.
 Total Cost Savings: 1.56%.
b) Since it is well seen that that there will be a costs saving for XX and YY in Part A, it is said to
well assume that around 3/7 of total cost savings would be allocated to XX and the remaining
amount that is around 4/7 would be well allocated to YY.

4DERIVATIVES
Swap Diagram
 The Effective Fixed Rate was calculated to be = 6.98%+0.64%-0.28% = 7.34%.
 Effective fixed rate (Using 3/7th of Cost Saving Amt.) = 8%-7.34% = 0.66%
 The fixed rate can be well calculated by reduction in the cost paid for XX. 7.64% Less
the benefit of swap of 0.66 would be around 6.98% for the cost.
Particulars Company XX Company YY
Floating Rate =L+0.28%-L+0.64%=0.36% =L+0.8%-L+0.28% = 0.52%
Fixed Rate = 6.98% =8%-6.98% = 1.02% =6.98%-6.6% =0.38%
Benefit Received =0.66% =0.9%
c) The direction of the swap would be in the form of cash inflow as the floating rate is higher
than the fixed rate which will be bringing an positive cash inflow of about $104,000 The Swap
Payoff ((8.02%-6.98%)/2)*$20000000 = $104000.

5DERIVATIVES
d) Interest Rate swaps are a widely used derivative tool which are widely used by banks an
financial institutions which are well used as a hedging tool or for the purpose of well mitigating
the forex or business related risks a company faces (Jermann and Yue 2018). Interest Rate Swaps
in particular are more concerned in relation with the changes that the interest rate would be
having to the parties entered into the contract for well aligning or meeting their aspects towards
the interest rate beliefs they have. The key reason why swaps carry a high default risks are
particularly due to the high credit risk or counterparty risk and value or price risk that is
associated with the interest rate swaps (Vallee, Augustin and Rich 2017). If the level of interest
rate changes, then the value associated with the swaps would be changing accordingly and the
credibility of the party who would be paying off to another becomes a liability in the contract. It
is important to note that since this is an Over the Counter Trade where there is no clearing house
or administration so mark to market value is generally not done and if the value of the swaps
changed predominantly due to then change in interest rate it increases the credit risk which in
turn increases high chances of counterparty default (Jarrow and Chatterjea 2019). The key
disadvantage of the OTC derivatives is that they are not mark to market unlike Exchange traded
derivative which are mark to market in which daily gains or loss are well settled of by
companies. However, in the case of OTC Derivatives the company may be exposed to a double
sword risk whereby if business operations risks turn out to be high and value to be paid in OTC
Interest rate Swaps turn out to be negative then there is a high chance that the company may be
unable to pay the same which in turn leads to default. The same case did happened in the
financial crisis of 2008, however, there are stringent rules nowadays where some portion of
margin needs to be deposited to a custom house so that there is some mitigation o credit risk
which in turn would reduce the default on interest rate swaps. Swaps also have an advantage that

6DERIVATIVES
they provides an investors with an effective key hedging tool for the purpose of well managing
their risk exposure and financial losses that can well occur. The strict measures are in turn taken
by exchanges so that the counterparty risk associated with the derivative contract gets mitigated
and there are less defaults.

7DERIVATIVES
References
Jarrow, R.A. and Chatterjea, A., 2019. Interest Rate Swaps. World Scientific Book Chapters,
pp.538-557.
Jermann, U.J. and Yue, V.Z., 2018. Interest rate swaps and corporate default. Journal of
Economic Dynamics and Control, 88, pp.104-120.
Purnanandam, A. and Weagley, D., 2016. Can markets discipline government agencies?
Evidence from the weather derivatives market. The Journal of Finance, 71(1), pp.303-334.
Robe, M.A. and Wallen, J., 2016. Fundamentals, derivatives market information and oil price
volatility. Journal of Futures Markets, 36(4), pp.317-344.
Vallee, B., Augustin, P. and Rich, P., 2017. Exotic Interest Rate Swaps: Snowballs in Portugal.