QUESTION 1

When a swap dealer makes market for the two counterparties of a swap, the dealer will usually have to bear various risks.

Explain how exchange rate risk and credit risk emerge in a currency swap (from a swap bank’s perspective).

NB: You must answer the question in your own words. (20 marks)

QUESTION 2

“Suppose that the US dollar has depreciated against the pound by 3% since last quarter, and the market price of 10-year US Treasury bonds has dropped by 2%. Therefore, a London-based pension fund investing in 10-year US Treasury bonds has incurred a loss of 3% + 2% = 5%. Furthermore, this calculation implies, in theory, that investors with foreign asset holdings should always be exposed to higher volatility than domestic investors with the same asset holdings due to exchange rate fluctuations.”

Comment on the accuracy and validity of the above statement.

NB: You must answer the question in your own words. (30 marks)

QUESTION 3

Although the covered interest rate parity (CIP) had held tightly during the 2000-2006 period, the Global Financial Crisis (GFC) during the 2007-2009 period saw significant deviations from CIP   given the heightened credit risk among financial institutions and the associated deterioration in  market liquidity.

More recently, persistent CIP violations have become the norm in the post-GFC period (i.e., from 2010 onwards). Specifically, the dollar basis, defined as the difference between the cash US

dollar (USD) interest rate and the FX-hedged/synthetic US USD interest rate, has been

persistently negative in the post-GFC period (see Figure 1), when US financial institutions have faced more stringent regulations on their balance sheets and non-US financial institutions have invested massively in USD-denominated assets such as US Treasury securities.

In contrast, positive dollar basis was more prevalent in the interwar period (1920-1939). For

example, the abandonment of the interwar gold standard by the UK in 1931 and by the US in

1933 escalated speculative pressures on other countries to follow suit by departing from the gold standard and allowing their currencies to devalue (see Figure 2 for the case of Belgium in 1935).

Explain how different key factors and mechanisms may have caused CIP violations in   opposite directions (i.e., negative vs positive dollar bases) in the two different contexts (i.e., post-GFC period vs Belgium in 1935).

NB: You must answer the question in your own words. (50 marks)