Though VAM Investments has a general preference for exchange-traded derivatives, the management of MPF is interested in knowing more about the use of OTC derivatives particularly swaps for managing the risks of their proposed investments in UK equities. Your line manager requires your report to cover this too.
Required:
A. Given that the investment will be exposed to both equity market risk and currency risk, explain the mechanics of an equity swap and a currency swap. (10 marks)
B. Illustrate the pricing of hypothetical equity swap contract (receiving $ Fixed Rate derived from $ Libor rates and paying the returns on Apple’s stock) and a currency swap contract (paying $ Fixed Rate and receiving £ Floating Rate); assume for both contracts a notional value of $1,000,000 and payments made quarterly for one year.
For currency swap, the £ notional value should be calculated based on the spot exchange rate on the day of your calculations. For any missing Libor term rates, assume that the term structure of interest rates is linear and upward sloping. Provide detail descriptions of each step and explain how the two contracts manage the risks involved. (12 marks)
C. Illustrate how the value of the equity swap contract changes one month after it is initiated. Provide details of your assumption.
