Finance Course Assignment: Treasury and Risk Management Solutions

This assignment solution addresses key concepts in Treasury and Risk Management, starting with an analysis of interest rate parity and covered interest arbitrage using provided spot and forward rates for the US and UK. It calculates the forward rate using the interest rate parity equation and investigates arbitrage opportunities. The second part delves into interest rate swaps, exploring cost savings for companies, effective fixed rates, and expected payoffs. It also examines the risks associated with interest rate swaps, including counterparty and default risks, while highlighting their role as financial derivatives. The assignment provides detailed calculations and explanations to illustrate the concepts.

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

1TREASURY AND RISK MANAGEMENT
Question 1
a) The Forward rate calculated via Interest Rate Parity is as follows:
Particulars Bid Offer
Averag
e
Spot Rate 1.255 1.260 1.258
Forward Rate 1.230 1.245 1.238
Interest Rate in US 3.00%
Interest Rate in UK 5.00%
Forward Rate 1.2340
(Interest Rate Parity)
The forward rate has been well calculated by taking the average spot rate and as shown below:
US Int Rate: 3% UK Int Rate: 5%
Forward Rate: Spot Rate: 1.258*(1+3%/1+5%)
Forward Rate: 1.2340
:b) The Arbitrage Method that can be well followed for the purpose of conducting Arbitrage the
steps that would be followed are as follows:
Investment Amount in £ £ 100,000
Convert into USD 1.2575
Amount in USD £ 125,750
Invest in US 3.00%
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

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Gross Amount Earned in £ £ 101,619.86
Less: Borrowed Amount £ 100,000.00
Net Amount Earned £ 1,619.86
c) The forward rates that are used in the Part A of the question is been well done on the basis of
Interest Rate Parity while on the other hand the forward rate that has been used is the 3 month
forward rate that has been well used for the purpose of calculation.
Question 2
a) If XX and YY has well agreed that the interest rate swap for the fixed rate would be P% (per
half year basis) against the LIBOR rate then the same is fair, this well means that the payment on
interest between XX and YY should be well equal, the cost savings would be as shown below.
Cost Saving occurs when parties take loan at a different rate from their borrowers that lead to
savings.
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%.

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Total Cost Savings: 1.56%.
b)
The Effective Fixed Rate = 6.98%+0.64%-0.28% = 7.34%. Thus the amount or the total 3/7th of
cost savings amount that will arising from the swap will be bank fixed rate minus the effective
fixed rate = 8%-7.34% = 0.66% (Purnanandam and Weagley 2016).
The P% fixed rate which is paid by XX to YY is calculated by reducing the cost which is
paid to XX. Thus, 7.64% less swap benefit of 0.66% which leads to the cost of 6.98% (Weagley
2019).
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%

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c) Expected Payoff from Swap ((8.02%-6.98%)/2)*$ 20000000 = $104000. The direction of the
swap would be on in the form of Cash inflow that it would be receiving as the floating rate is
8.02% and the fixed rate calculated for the swap has been around 6.98%, giving an total cash
inflow of about $104,000.
d) The interest rate swaps are an agreement between the two parties for well exchanging one
stream of interest payments with the other sets over a given set of time period (Weagley 2019).
Swaps are an important derivative contract which are used by the companies as an key Over the
Counter derivative contract. The application of the swap rates are nowadays generally used by
banking and financial institutions for the purpose of well hedging their credit risk and as well as
mitigating forex or business related risks. The two key risks that is well associated with the
interest rate swaps can well help companies and individuals go through default risks is generally
due to the nature of derivative contract that is Over the Counter Trade, in which credit risk is the
key thing which play a pivot role in the default of counterparty as there is no initial margin nor
any mark to market that is associated with the derivative contract. For example if ABC and XYZ
Company enter into a trade or contract which would involve to pay fixed and XYZ would be
paying floating. Now if the interest rate well increases to a high level from 2% to 6% and the
same happens overs a trade period of six months then it has earned a loss of 4% on the notional
amount. Since, the interest rate changes on a continuous basis and the marking of the derivative
contract is done after a period of four months this in turn increases the value that is due from one
party to another. If the value to be paid is considerably to high this in turn would be increasing
the credit risk and make one of the counterparty default in the same, which in turn would be
leading to counterparty risk. Thus a Derivative Contract like Interest rate swaps in turn do

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increase the default risk as there is no clearing house and no margin which are deposited on a
daily mark to market basis. However, after the financial crisis of 2008 exchanges have well said
that there should be some of the margins that should be deposited in the clearing house in order
to avoid the credit risk which occurs in OTC Derivatives. Thus, absence of daily mark to market
feature along with the high pricing risks are some of the key risk which leads to default and
counterparty default in interest rate swaps. Other benefits like hedge as a financial derivative and
effective tool for prevention of one sided losses are some of the ley features which makes the
tools effective for application.

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Bibliography
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.
Weagley, D., 2019. Financial sector stress and risk sharing: evidence from the weather
derivatives market. The Review of Financial Studies, 32(6), pp.2456-2497.
Weagley, D., 2019. Financial sector stress and risk sharing: evidence from the weather
derivatives market. The Review of Financial Studies, 32(6), pp.2456-2497.