Interest Rate Parity and Swap Questions

The following information is available to investors:

Spot rate : £1 = 1.2550 - 1.2600

Forward rate (3 months) : £1 = 1.2300 - 1.2450

New York interest rate (mid-rate)  : 3 % per annum

London interest rate (mid-rate)    : 5 % per annum

1. Using the parity equation in the course material, test for interest rate parity between the United States and Britain over a 3-month period.Use the mid exchange rates. If parity is absent, find the parity forward (mid) rate.

2. Conduct covered interest arbitrage to investigate the presence of arbitrage profits over a 3-month period. Assume the investor has £100,000 to either invest in a sterling deposit or to convert the sterling amount to US dollars. If parity is absent, find the parity forward rate through the money market mechanism.

3. Explain the difference in the parity forward rates in part 1 and part 2 above.

Company XX can borrow USD million at a fixed interest rate and at floating rates for  years from Bank A. XX would to borrow at fixed rates on a semi-annual basis. Bank A offers the following pricing schedule for month US dollars LIBOR, where the rates are mid-rates.

1. What total cost savings (basis points per half year) is available if initially XX borrows at a floating rate from its bank and YY borrows at a fixed rate from its bank, and then they enter into an interest rate swap? XX and YY agreed that a swap of fixed rate P% (per half year) against LIBOR is fair.   

2. Assume that the swap between XX and YY requires floating rate payments at 6-month   LIBOR.

Design a swap that allocates 3/7 of the total cost savings to XX and the balance to YY. Draw the swap diagram.

After the swap, what is XX’s final fixed rate (per half year) on its loan?

What is the fixed rate (P% per half year) does XX pay YY in the swap?

What is YY’s final floating rate (per half year) on its loan?  

3. If LIBOR turns out to be 8.02 percent for the next swap settlement, calculate the swap settlement sum. What is the direction of settlement and why?

4. Evaluate the level of default risk in interest rate swaps.