Explanation:
A swap contract is equivalent to a portfolio of forward contracts with identical delivery prices and different maturities. Consequently, swap contracts are similar to forwards in that (1) at any date, swap contracts can have positive, negative, or no value, and (2) at initiation, the fixed amount paid is chosen so that the swap contract is costless. The unique fixed amount which zeros out the value of a swap contract is called the swap price.
A 5-year contract to pay dollars and receive Euros is equivalent to a series of 5 forward contracts to exchange a set amount of dollars for Euros on specified future dates.
In the case of a 5-year contract to pay dollars and receive Euros, one party would agree to make a series of payments in dollars over the 5-year period, while the other party would agree to make a series of payments in Euros. The exchange rate used to determine the amount of each payment would be specified at the outset of the contract.
This contract can be replicated using a series of 5 forward contracts, where each contract specifies the exchange rate and the date on which the exchange will take place. By entering into these forward contracts, the parties can effectively lock in the exchange rate for each payment and eliminate the risk of currency fluctuations.
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Q.1522 To determine the value of forward contracts, we decompose the forward contract into its main building blocks which will impose the net effect on the risk and price of the forward contract. This methodology can also be used for long-term currency swaps which are typically identical to portfolios of forward contracts. Keeping this scenario in mind, which of the following statements is true?
A
A 5-year contract to pay dollars and receive Euros is equivalent to a series of 5 forward contracts to exchange a set amount of dollars per year.
B
A 5-year contract to pay dollars and receive Euros is equivalent to a series of any number of forward contracts to exchange a set amount of dollars per year.
C
A 5-year contract to pay dollars and receive Euros is equivalent to a single forward contract to exchange a set amount of dollars per year.
D
A 5-year contract to pay dollars and receive Euros is not equivalent to a series of 5 forward contracts to exchange a set amount of dollars per year.