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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against forex risk

Alpha plc swaps £8 million for US$10 million at the spot rate of US$1.25/£ under a 3-year currency swap. Alpha pays 4% fixed on the dollar principal and receives 3% fixed on the sterling principal, annually. What is Alpha's net annual interest cash flow, in dollars, if the sterling receipt is converted at the swap rate of US$1.25/£?

Alpha makes a net annual payment of US$100,000. It pays US$400,000 interest on the dollar principal and receives £240,000, worth US$300,000 at 1.25, so the net outflow is the difference of US$100,000.

  1. APays US$100,000Correct
  2. BPays US$500,000
  3. CPays US$400,000
  4. DReceives US$100,000

Explanation

Alpha pays 4% x US$10m = US$400,000. It receives 3% x £8m = £240,000, which at 1.25 is US$300,000. Net payment is US$400,000 - US$300,000 = US$100,000. Using 4% less 3% on the principal wrongly ignores that the rates apply to different amounts.

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