University Finance Assignment: Interest Rate Parity and Swaps Analysis

This assignment delves into two key areas of finance: interest rate parity and interest rate swaps. The first question examines interest rate parity, explaining its role in forex markets, calculating forward rates, and identifying arbitrage opportunities. It explores the relationship between spot rates, forward rates, and interest rate differentials, illustrating how deviations from parity can lead to arbitrage profits. The second question focuses on interest rate swaps, analyzing their mechanics, benefits, and risk. It explains how swaps can be used to manage interest rate risk, calculate cost savings, and determine settlement payments. The assignment also discusses the risks associated with swaps, including price and default risk, and how these risks can be mitigated.

Running head: QUESTION AND ANSWERS
Question and Answer
Name of the Student:
Name of the University:
Author Note:

1QUESTION AND ANSWERS
Answer to Question 1:
Part 1:
The interest rate parity means the forward rate should be equal to the interest rate
differential between the two countries multiplied by the spot rate. Thus the interest rate parity
highlights that the difference between the forward rate and the spot rate should be equal to the
difference between the interest rate between the two countries. This has an immense role to
play in the forex markets as if the interest rate parity does not hold good then investors can
earn arbitrage profits by taking relevant position in the currency.
Thus as per the question, the spot rate and the forward rates have been provided with
the bid ask rate. The bid rate is the rate at which the investor can sell to the bank and the ask
rate is the rate at which the investor can purchase from the bank. Thus for simplicity of
calculating interest rate parity mid rates are taken for the same.
Mid Spot Rate = 1.2575
Mid Forward Rate = 1.2375
Forward discount Premium = ((1.2375-1.2575)/1.2575)*100 = 1.59%
Interest rate US 3% UK 5%,
Hence interest rate differential = (5-3) % = 2%
Hence arbitrage is possible since the interest rate differential is not equal to the
currency differential. Thus the formula for IRP is given by,
Forward Rate/ spot Rate = (1+US)^N/(1+UK)^N
Forward Rate = 1.2575*((1+0.03)^3/12/(1+0.05)^3/12)

2QUESTION AND ANSWERS
Forward Rate = 1.251
The Forward parity rate is the rate which should be the exchange rate after the time
period which is equal to the interest rate differential of the two countries multiplied by the
spot rate. If the rate is not equal to the forward rate, then the investor has an opportunity to
generate arbitrage profits. The mid rates from the spot and the forward rates for both the
currency is calculated, which is used in the parity equation. Thus the interest rate for the both
the country is taken and used in the parity equation, which provides the forward rate of $
1.251 per euro. Thus the forward rates of the currency is not equal to the parity forward rate
which is calculated.
Part 2:
The interest rate arbitrage can be defined as borrowing in low yielding currency and
investing in high yielding currency. The arbitrage profit is earned when the interest rate parity
does not hold good and the investor makes more money than it was supposed to from the
investment. Thus the interest rate arbitrage is highlighted in the following steps.
Step 1: The amount which needs to be invest is pound 100000.
Step 2: convert the pound into spot dollars at the exchange rate of 1.255 which is the bid rate.
The dollar which is received is 125500.
Step 3: Invest the dollar which has been converted for 3 months at the US interest rate which
is 3%. Thus the amount after 3 months is 126430.84 dollars.
Step 4: This amount which is received in dollars is converted in pound at ask forward rate of
1.245. Thus the pound which is received is 101550.
Step 5: If the pound 100000 would had been invested at 5% UK rate the pound amount would
had been 101227.22.

3QUESTION AND ANSWERS
Step 6: Thus arbitrage profit from the transaction is pound 323.65.
Thus since the transaction was covered the effective exchange rate which was locked
by the company from the above transaction is 126430.84/101227.22 = 1.249.
Thus as per the money market mechanism the parity forward rate for the currency pair
is $1.2489. Thus this is not equal to the parity forward rate calculated from the parity
equation. The forward rate as per the money market mechanism implies that if the position in
the foreign currency is left open and not covered the rate which should be present should be
equal to the forward rate of the currency. Thus, it is the effective exchange rate at which the
company can convert its currency, ignoring taxes and transaction cost.
Part 3:
The parity equation takes into account the spot rates, the interest rates for both the
countries when the forward rate is calculated. In the money market mechanism, the forward
rate is calculated by dividing a set amount invested in one currency by the same amount
invested in other currency (Du, Tepper and Verdelhan 2018). The difference which is of
$0.02 is on account of the fact of the effect of the spot rate. In uncovered IRP the spot rate is
the rate for conversion, and gives a specific set of amount which is invested in the market rate
for a specific time period. Thus the amount which earned is not covered and is exchanged on
the day of the investment horizon ends (Han 2018). Thus the difference between the interest
rates and the exchange rates should be equal to avoid arbitrage. However, since the difference
is not equal it gives rise to arbitrage opportunity which is exploited by the investors (Lothian
2016).

4QUESTION AND ANSWERS
Answer to Question 2:
Part a:
Two parties enter into a swap to benefit from the financial transaction by saving the
interest rate which is being paid to the borrower. Thus a company receives loan at a lower
fixed interest rate while another party receives loan at lower floating points. Thus the
difference among the two loan rates lead to savings in the total cost which is incurred by both
the parties and is defined as total cost savings. If the loan rates for both the borrowers would
had been the same the total cost saving would had been 0.
The total cost savings of the swap entered is analysed using the difference among the fixed
rates, the floating rates and the spread which both the parties are privy. Thus the comparative
advantages sum highlights the total cost savings from the Swap entered by both the parties.
Figure: 3
Source:
Thus as per the figure highlighted the total cost savings from the swap between XX
and YY is 62 basis points for half year, while 124 basis points on an annual basis.
Part b:
The Swap Diagram of between the two parties is highlighted in the figure below,

5QUESTION AND ANSWERS
XX YY
A BFixed Leg 6.73%
Floating Rate= Libor
Libor+0.24
%% 6.6%
Figure: 4
Source:
The fixed leg of the swap is 6.73%, while the floating leg of the swap is Libor. Thus
the Company XX will pay a Swap Fixed Rate of 6.73% to YY and the company YY will pay
the 6 month Libor to Company XX.
The final Fixed Rate for the loan which would be paid by the company XX for the
$20 million taken by the company is calculated in the figure below,
Figure: 5
Source:

6QUESTION AND ANSWERS
The loan would had cost the company XX at 8%, if it would had taken directly from
the bank. However, the company pays a fixed rate on the leg of the swap at 6.73% to
company YY. The spread on the loan is added to the cost which is paid to company YY
which is 0.24%. Thus the total cost of the loan at the fixed rate for the company is 6.97%, and
the 3/7th part of the cost saving from the loan is 0.27% as the company needs to pay the loan
to the bank at libor+0.24%.
The Fixed leg of the swap which is paid by the company XX to company YY is
calculated and presented in the steps below,
Step 1: Libor rate 7%
Step 2: Cost saving for XX 0.27%
Step 3: P%= 7%-0.27%=6.73%.
The company needs to pay a loan rate to the bank at floating + 0.24%. However, the
cost of the swap for the company XX is 6.73%, which it pays to the company YY in the
Swap. The final floating rate which is paid by the company YY for the Swap is calculated
and highlighted in the figure below,
Figure: 7
Source:

7QUESTION AND ANSWERS
The final floating rate which is paid by the company YY on the swap is 7%, which is
the Libor which is paid by the company YY. The company YY would had needed to pay
7.2% if it had taken loan from the bank itself, thus saving 0.2% in the floating leg. Also the
company receives, 6.73% from the company XX and only needs to pay 6.6% to the bank,
hence have saved 0.13%. Thus the Floating rate locked in by the company YY is Libor-
0.33%.
Part c:
The swap settlement which would take place when the Libor Rate is 8.02% is
calculated and highlighted in the figure below,
Figure: 8
Source:
Thus the Libor is 8.02%, while the Swap fixed rate is 6.73%, hence the company XX
would receive from company YY the difference of the rates which is multiplied by the
notional amount and then divided by 2 since the swap is half yearly. Thus the payment which
would be received by the company XX is $128571.43. The swap is moving in this direction
since, the company YY thought the interest rates would decline in future and converted their
fixed rate borrowing to floating rate. However, the interest rates increased, and thus the
company XX would receive payment from YY which is the amount $128571.43.

8QUESTION AND ANSWERS
Part d:
Interest rate swaps are contracts which are entered by two parties where the
underlying is the interest rate. Thus the swap is formally consists of a floating leg and a fixed
leg, the value of the swap at the initiation of the contract is calculated to be 0. Thus the fixed
leg of the swap is equal to the floating leg of the swap at the initiation of the contract. The
swap is a contract between two parties and unlike other derivatives such as futures and
options they are not covered by the clearing houses, hence they are over the counter contracts
(Al-Own, Minhat and Gao 2018).
Thus the swaps are generally facing two types of risk, one is the price risk and the
other is the default risk. The price risk of the swap can be hedged by taking alternating
positions, however default risk is a cause of concern for both the parties. Thus, in a falling
interest rate environment the floating leg payer needs to make less payments then the fixed
rate payer and hence is in the money for the swap (Gautam 2019). Thus an opposite scenario
occurs, when the interest rates are rising the fixed leg payer is said to be in the money. The
default risk can rise from termination of the swap which can be provided in the indenture, to
occur when a specific events occur. This can be when a party defaults payment or one of the
party credit rating falls below a certain level. Thus the cost of default of the swap is
calculated by taking the replacement cost of the swap, which would be entered with the
similar terms (Cooper and Mello 2019).
Thus the risk can also be due to some terms such as one of the party files for a
bankruptcy and thus the default risk in the swap takes place. However, a settlement clause in
the swap might change the due course of the swap when one of the party defaults, which is
however in the favour of the defaulting party (Kisman 2016). Thus if the swap is defaulted
and the defaulting party has a positive value in the swap, the other party needs to pay the
defaulting party the cost of replacement of the Swap. However, thus the credit risk or the

9QUESTION AND ANSWERS
default risk is extremely high in the swap as the defaulting party could not pay the dues when
the swap defaults, but can collect the payment when they have a positive value (Thalassinos,
Stamatopoulos and Thalassinos 2016).

10QUESTION AND ANSWERS
References:
Ali, I., Gohar, A. and Meharzi, O., 2017. Why do firms change their dividend
policy?. International Journal of Economics and Financial Issues, 7(3), pp.411-422.
Al-Own, B., Minhat, M. and Gao, S., 2018. Stock options and credit default swaps in risk
management. Journal of International Financial Markets, Institutions and Money, 53,
pp.200-214.
Baker, H.K., Kilincarslan, E. and Arsal, A.H., 2018. Dividend policy in Turkey: Survey
evidence from Borsa Istanbul firms. Global Finance Journal, 35, pp.43-57.
Cooper, I. and Mello, A.S., 2019. The default risk of swaps. Institute of Finance and
Accounting.
Du, W., Tepper, A. and Verdelhan, A., 2018. Deviations from covered interest rate
parity. The Journal of Finance, 73(3), pp.915-957.
Gautam, P., 2019. Agency Costs and Dividend Policy: A Review of Theories and Empirical
Evidence. Journal of the Gujarat Research Society, 21(16), pp.1229-1234.
Kisman, Z., 2016. Disappearing Dividend Phenomenon: A Review of Theories and
Evidence. Transylvanian Review, (3).
Lothian, J.R., 2016. Uncovered interest parity: The long and the short of it. Journal of
Empirical Finance, 36, pp.1-7.
Murtaza, M., Iqbal, M.M., Ullah, Z., Rasheed, H. and Basit, A., 2018. An Analytical Review
of Dividend Policy Theories. Journal of Advanced Research in Business and Management
Studies, 11(1), pp.62-76.

11QUESTION AND ANSWERS
Thalassinos, E.I., Stamatopoulos, T. and Thalassinos, P.E., 2016. The European sovereign
debt crisis and the role of credit swaps. In THE WORLD SCIENTIFIC HANDBOOK OF
FUTURES MARKETS (pp. 605-639).
Han, R., 2018. The Impact of Exchange Rate Volatility on Portfolio Investment.
Nirmali, H. and Rajapakse, R.P.C.R., 2016. The Uncovered Interest rate Parity-A Literature
Review.
Har, W.M., Tan, A.L., Lim, C.H. and Tan, C.T., 2017. Does Interest Rate Still Matter in
Determining Exchange Rate?. Capital Markets Review, 25(1), pp.19-25.