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Answer: Zero
At the bankruptcy date, the bank’s remaining swap position is valued by comparing the two bond legs. - The EUR leg has a coupon rate equal to the EUR discount rate (7.0%), so its value is approximately **€70 million**. - The USD leg has a coupon rate equal to the USD discount rate (4.0%), so its value is approximately **$100 million**. - Convert the EUR leg to USD at the bankruptcy exchange rate: - €70 million × $1.40/€ = **$98 million** So the swap value to the bank is: - **$98 million − $100 million = -$2 million** That means the swap is **out of the money** to the bank. If Company X defaults, the bank has **no credit exposure** on this position because it is not owed money by the counterparty. Therefore the correct answer is **Zero**.
Author: Manit Arora
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Question 1.3. [This practice question is noticeably more difficult than an exam question but it invokes building blocks] A bank has entered into five (5)-year currency swap with Company X. Under the swap, the bank receives interest at 7.0% per annum in Euros and pays interest at 4.0% in dollars (USD). The principal amounts are $100 million USD and 70 million EUR; interest payments are exchanged once per year. At the end of year three (3), Company X declares bankruptcy when the EUR/USD is $1.40; i.e., $1.40 USD per unit EUR. Finally, at the time, both spot (zero) interest rate curves are flat: EUR at 7.0% and USD at 4.0% for all maturities with annual compounding. (All interest rates are quoted with annual compounding). When Company X declares bankruptcy, at the end of year three (3) before the T+3 exchange takes place, what is the cost (credit exposure) to the bank?
A
Zero
B
$225,075
C
$860,000
D
$1,214,367
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