1. Explain how you would value a swap that is the exchange of a floating rate in one currency for a fixed rate in another currency.

2. Suppose that the term structure of interest rates is flat in the US and UK. The USD interest rate is 2.5% per annum and the GBP rate is 2.9% p.a. Under the terms of a swap agreement, a financial institution pays 3% p.a. in GBP and receives 2.6% p.a. in USD. The principals in the two currencies are GBP20 million and USD32 million. Payments are exchanged every year, with one exchange having just taken place. The swap will last 3 more years NB: Find the current value of the USD / GBP when you complete this question.

(i) Write out the formula for the valuation of a currency swap in terms of bond prices. From this formula, explain what prices and/or rates you need to calculate the value of a swap.

(ii) Show the payments to be made in a table and then calculate the value of the swap to the financial institution. Assume all interest rates are compounded continuously.