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    Currency swap

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    A U.S. Company has a foreign subsidiary in London. Concerned about translation risk for the upcoming fiscal year (beginning in 60 days), the treasurer of the U.S. company is contemplating entering into a currency swaption expiring in 60 days with an exercise rate of 5.24%(pounds)/3.84%(dollars). The underlying swap is a conventional fixed-for-floating with a term of one year (corresponding to the fiscal year) and settlements on a 90/360-day basis. The notional principal is 18million pounds, the average budgeted subsidiary quarterly revenues for the upcoming fiscal year. Given the following information:
    Current exchange rate: US$1.8395 U.K. 0.5436 pounds
    Term structure:
    60-day US 2.95% u.K. 3.78%
    150-day US 3% U.K. 3.81%
    240-day us 3.20% u.k. 4.89%
    330-day us 3.45% u.k. 5.01%
    420-day US 3.87% U.K. 5.32%

    How do I go about calculating the price and structuring the terms of the underlying swap?
    From the treasurer's perspective, how do I go about calculating the price of the swaption?

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    Solution Preview

    In the currency swap, it is necessary to predict the spot rates of GBP (pound) for the following year. In this case, the US firm is more concerned about a drop in $/₤ rate, and they will swap in USD by their GBP subsidiary in London. In this case, we will show how to compute the float rate (varies with the interest rate) of the SWAP, because the fixed rate is predetermined by the contractors.

    At present, 1.8395 $ = 1 ₤, same as 1$ = 0.5436₤
    In the US, the forward rate from now to 60 days is (5.24%*60/360) = 0.873%, and that in UK is 3.84%*60/360) = 0.64%
    We assume that interest rate parity holds in this case. (Interest rate parity is an arbitrage condition, which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while ...

    Solution Summary

    This shows how to determine price and terms for a currency swap.