Answer to Question 1:

Part 1:

hInterest parity is derived using four parameters which is the spot rate, the forward rate, and the interest rate between the two countries. Thus the spot rate is the rate at which the currency can be exchanged at the present moment, while the forward rate is the rate at which the currency can be exchanged in the future. The difference between the spot rate and the forward rate between the two currencies should be equal to the interest rate differential between the two countries. Thus when the interest rate differential is equal to the difference of the forward and the spot rate, then the interest rate parity is present as the forward rate (Cheung, Chinn, Pascual and Zhang 2019).

The bid and ask rate for the spot rate and the forward rate is provided in the calculation, hence the question requires the calculation of the mid rates for the spot and the forward rate which is provided below,

Step 1: Formula

Spot Rate (Mid-Rate) = (Bid rate + Ask Rate)/2

Forward Rate (Mid-Rate) = (Bid rate + Ask Rate)/2

Step 2: Calculation

Spot Rate (Mid-Rate)= ($1.255+$1.26)/2 = $1.2575

Forward Rate (Mid-Rate)= ($1.23+$1.245)/2 = $1.2375

Thus to determine whether the interest rate parity holds good or not, a parity test is conducted to analyse the difference between the interest rate and the Forward rate – spot rate.

Interest rate differential	Difference between forward rate and spot rate
(US interest Rate-UK interest rate)/(1+UK interest Rate)	(Forward rate-Spot Rate)/Spot Rate
(3%-5%)(1+5%)	($1.2375-$1.2575)/1.2575
-0.02/1.05	-$0.02/1.2575
-0.01905	-0.01590

Thus, since the interest rate differential is not equal to the difference in the forward and the spot rate. The interest rate parity condition does not hold good. Thus the forward rate which should had been as per the Interest rate parity is given below,

The parity Forward Rate is given by the following formula, however since the interest rates are given on an annual basis they need to be converted on a quarterly basis. Hence the formula for the same is,

Parity Forward Rate (Mid-Rate) = (Spot Rate* (1+US interest Rate)^3/12)/(1+UK interest Rate)^3/12

      = ($1.2575*(1+3%)^3/12)/(1+5%)^3/12

      =$1.251

Thus the forward rate which is in the market is $ 1.2375 per pound, while the forward rate as per the interest rate parity equation is $ 1.251 per pound. Thus the interest rate parity does not hold good and the investor has an opportunity to earn arbitrage profit.

The arbitrage profit is the profit which can be earned by the investor without taking any additional risks and is also known as riskless profit. Thus, since the Forward rate should had been $1.251 however, it is in the market being quoted at $1.2375. The investor can borrow the currency at the UK interest rate and convert it using spot rate into USD which it can invest at the US interest rate. The amount which needs to be repaid back can be converted at the forward rate being quoted in the market. Thus if the situation remains stable the investor could earn an arbitrage profit of 2%-1.59%= 0.41%.

Part 2:

Thus arbitrage profits can be generated by investors when the interest rate parity does not hold good. This profit is the risk free profit which is generated by the investor, when the interest rate parity does not hold (Har, Tan, Lim and Tan 2017). The process for earning the arbitrage profit is provided in the following steps, which is highlighted in the bullets below,

• Borrow amount at a low yielding currency say Japanese yen.
• Convert the amount borrowed to a high yielding currency such as the US dollar at the spot rate.
• Invest the amount which has been received at the interest rate which is prevailing in the United States.
• Thus the amount has been invested for a specified period of time say 3 months.
• Convert the US dollars to the Japanese yen at the forward rate. This is the Japanese yen which has been generated.
• Calculate the total amount which is repayable at the end of 3 months for Japanese Yen.
• Thus the difference between the converted Japanese yen and the amount which is payable after 3 months is the arbitrage profit.
• However, sometimes it can lead to a loss, thus at that point of time the borrowing currency would be the US dollars while the investing currency is the Japanese Yen to derive the profits from the trade, which is the arbitrage profit.

There are two options which are available with the investor with which they can invest the funds which is available with them. Thus the two options are highlighted below and the best option is selected for the investor,

Alternative 1: The investor can invest the pound 100000 at the UK interest Rate for a period of 3 months.

The interest rate in the United Kingdom = 5% per annum

Return from the deposit after 3 months = Pound 100000*(1+5%)^3/12 = Pound 100000*1.01227 = Pound 101227.22

Alternative 2: Convert and invest in the US dollars

Step 1: convert the pound into spot dollars at the exchange rate of $ 1.255 per pound which is the bid rate.

=Pound 100000*$1.255 = $125500

Step 2: Invest the dollar which has been converted for 3 months at the US interest rate which is 3%.

Return from the deposit after 3 months = $125500*(1+3%)^3/12 = $125500*1.007417 = $126430.84

Step 3: This amount which is received in dollars is converted in pound at ask forward rate of $ 1.245 per pound

$126430.84/$1.245 = 101550 Pound

Step 4: Arbitrage Profit is the amount which has been generated by investing in UK less the amount which has been generated in alternative 2.

=(101550-101227.22) Pound = 323.65 Pound

Step 5: Effective exchange rate = 126430.84/101227.22 =$ 1.249 per pound.

Thus the arbitrage profit from the above covered interest rate parity is pound 323.65, while the effective exchange rate is $ 1.249 per pound. Thus the exchange rate which the company has been able to lock from the covered interest rate parity is $ 1.249 per pound, while the forward rate which is being $ 1.245 per pound. Thus the exchange rate is not equal and the parity forward rate through money market mechanism does not hold good (Kemboi and Kosgei 2018).

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. 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. 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 (Medhora 2017).

The difference between the rates as per IRP and money market mechanism can also be due to the volatility factor. Thus, as highlighted with an increase in the volatility or fear among the investors, the exchange rate fluctuates both at the spot rate and the forward rate. Thus, it can lead to the interest rate parity to not hold good and can lead to difference in exchange rates.

Answer to Question 2:

Part a: 

Part i: Explanation

A swap is an agreement which is entered by two parties who contract with each other under some agreement, usually with the help of a financial intermediary. The swap is an over the counter specialized contract, which means it is not traded at any exchanges. The swaps can be formed for any kind of transaction, while the most common being the interest rate swap and currency swap.

The currency swap is a swap where two parties contract to exchange a certain amount of currency which is the notional principal. Thus, currency swap actually requires the exchange of the notional principal at the initiation of the swap, which is returned at the end of the swap term. The swap term can be for a long period of time, with periodic payments which can be quarterly, semi-annually or annually (Nirmali and Rajapakse 2016).

The interest rate swap is a swap which is entered by two parties to effectively reduce the cost of borrowing. One of the parties pays the other at a fixed rate, while the other party pays at a floating rate. Unlike currency swap no notional principal is exchanged at the initiation of the swap contract, however periodic payments are made according to the terms of the swap.

The total cost savings is the effective reduction in interest rate which occurs when two parties enter into a swap. Thus, one party can borrow at a lower fixed rate and floating rate, while another party needs to pay higher of the rates. Thus, a swap arrangement is entered by both the parties to reduce the effective cost of borrowing between the two parties which is referred to as total cost savings (Nwiado and LeneeTorbira 2016).

Part ii: Calculation

The company XX can borrow at a fixed rate of 8%, while at a floating rate of Libor + 0.24%. The bid ask spread which is offered by bank A is 0.4%. The Company YY can borrow at a fixed rate of 6.6% while at a floating rate of Libor +0.2%, the bid ask spread offered by bank B is 0.6%. Thus the effective total cost savings from the swap is provided in the following table,

Particulars	XX	YY	Difference
Fixed Rate	8%	6.6%	1.4%
Floating rate	Libor +0.24%	Libor +0.2%	-0.04%
Bid ask Spread	0.4%	0.6%	0.2%

Step 1: Difference among the fixed rate for both the company:

XX-8% YY-6.6%

Difference = 8%-6.6%= 1.4%

Step 2: Difference among the Floating rate for both the company:

XX-0.24%YY-0.2%

Difference = 0.24%-0.2%= 0.04%

Step 3: Difference among the Bid ask Spread for both the company:

XX-0.4%YY-0.6%

Difference = 0.4%-0.6%= -0.2%

Step 4: Thus the total cost savings for the companies using the swap arrangement is

Total Cost Savings = add difference of fixed rate+ Less difference of floating rate+ add difference of bid ask spread.

=1.4%-0.04%+0.2%= 1.56%

The incentive for both the parties to enter into a swap is the presence of the cost savings which has been calculated above as 1.56%. This is because one company say XX might have poor ratings which lead to receiving of loan at higher rates while the other company has improved ratings which lead to lower cost of borrowing. Also the belief for each of the company in regards to the exchange rate is different and want to borrow at either fixed or floating rates. Thus the company XX which aims to borrow at the fixed rate due to fear of rising rates is not able to borrow at those rates due to the rates being high, hence they borrow at floating rates and enter the swap as fixed payer. The company YY expects interest rate to fall hence intends to borrow at floating rates but the rates are not favourable for the company and hence borrows at fixed rate.

Thus as per the interest rate expectations the companies enter the swap where XX is the Fixed rate payer while YY is a floating rate payer. Thus this is possible only because the companies can borrow at different rates. If the rate of borrowing would had been same for the companies, there would had been no benefit to the companies when entering into a swap.

Part b:

Part i: Swap Diagram

The swap which is entered by the two companies is of the following structure, company XX will pay at a fixed rate while the company YY will pay at the floating rate. Thus, the company XX borrows from bank A at a floating rate of Libor +0.24% + spread of 0.4%. Thus, the cost of borrowing for company XX is 7.64%, while company YY will borrow from the bank B at a fixed rate of 6.6%.

This is because the fixed rate for company XX is 8% while the floating rate is 7.64%, and the company YY has a fixed rate of 6.6% and a floating rate of 7.8%. Thus the company XX has a comparative advantage to borrow at floating rate, while company YY has an advantage to borrow at fixed rate. Thus the swap which would be entered by the company is provided in the following diagram (Petrović, Kerković and Jocić 2019).

Part ii: Fixed Rate which is paid by X

Thus the swap diagram which would be entered by the two companies is shown in the figure above. The final fixed rate which would be paid by XX after swap is the swap rate of 6.98% and the premium of 0.64%. Thus the effective fixed rate for the company is 6.98%+0.64% = 7.62%.

Part iii: P% fixed rate which is paid along with the Floating rate

The P% Rate which is paid by XX to YY is calculated by deducting the cost which the XX pays to bank A which is 7.64% less the swap benefit of 0.66% which is 6.98%.  The floating rate which is paid by the company YY at the initiation of the swap is Libor +0.28%. Thus the determination of the swap benefit and savings for each of the company is highlighted in the table below.

The total swap benefit which is received by both the companies is 1.56%, 3/7^th is given to XX while 4/7^th is provided to YY. Hence XX share of cost savings is (1.56/7)*3 =0.66%, while YY share of benefit is (1.56/7)*4 = 0.9%.

Particulars	YY	XX
Fixed Rate = 6.98%	=6.98%-6.6% =0.38%	=8%-6.98% = 1.02%
Floating Rate	=L+0.8%-L+0.28% = 0.52%	=L+0.28%-L+0.64%=0.36%
Benefit Received	=0.9%	=0.66%

Part c:

Thus the value of the swap in the next settlement date when the Libor is 8.02% is provided in the following steps.

Step 1: The company XX needs to pay 6.98% to YY while the company YY will pay 8.02%+0.28%= 8.3%.

Step 2: The Swap direction would be company YY would pay company XX as company XX has won the swap bet.

Step 3: The payoff from the swap would be ((8.3%-6.98%)/2)*$ 20000000 = $132000

Thus as the swap which was entered by the companies was for the company XX to enter as a fixed rate payer, while company YY to be as a floating rate payer. The expectation of XX for the interest rate to rise was correct as the Libor rate increased to 8.02%, where it was 7%. Thus, the company XX needs only to pay the fixed rate of 6.98%, while the company YY needs to pay floating rate of 8.02%. Thus, the payoff has been from YY to XX leading the company XX to win the bet while the company YY has lost money on the swap.

Part d:

The swap arrangement which is entered by two companies or parties is customised which means they are negotiated terms with which the two parties enter into the contract. As other products such as put, call, futures which are exchange traded swap arrangement is over the counter arrangement. Thus they are not backed by the exchange, as in exchange traded products, they have a clearing house which maintains that none of the transacting party defaults. However in swaps another party can default from the contract which creates a risk for default (Yoon and Jei 2019).

The meaning of default is defined in the swap contract and as which event can be considered as a default. This can be if one party fails to pay the swap obligation, or has its credit rating reduced from a certain level. Thus all this can be categorized as default of the swap and other party can rescind from the contract. The other type of risk which is faced in the swap arrangement between the two parties is the pricing risk. This risk can be hedged by the swap parties by taking alternative position in other instruments. The default risk is a cause of concern for the parties as this risk is dependent on the other party. Thus for instance two companies entered in fixed floating swap arrangement, where A pays fixed rate while B pays Floating rate. The Libor increases and then the company B needs to pay company A the difference of the interest rate, hence company A is facing default risk. However, in the next settlement period the Libor falls and hence here company A is liable to pay company B in this period and company B is facing default risk (Ali, Gohar and Meharzi 2017).

This risk is also increased as when the payer in the swap contract has defaulted the receiver would need to forego the amount which is to be received or charge for a corporate litigation for settlement. However, when the receiver of the swap has defaulted the payer would need to make the necessary payment to the swap to the receiver and honour the obligation.

However, the risk in the swap can be reduced by the inclusion of settlement clause in the swap contract. This suggests the terms of arrangement of payment of the swap when either party defaults and hence tends to mitigate some risk in the swap (Cooper and Mello 2019).

The risk of default was observed mostly during the credit crisis in the year 2008 when the counterparties were defaulting on the arrangement of the swap. Thus, it lead to the rise in the exposure of the financial losses for the companies, which got extended during the financial crisis. Thus, the swaps were made post the credit crisis to somewhat hedge the risk arising from the default by the counterparty (Kisman 2016).

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