Answer ALL questions in depth.
Description:
The Mexico City office of a large U.S. bank is asked by clients to develop currency swaps, a derivative financial product. This case deals with the new product development process in financial services, and
the problems and issues that are raised in product development in a volatile environment. The case is set in pre-tequila crisis Mexico; however, the assignment will cause you to examine currency movements
before/after the onset of the crisis in December 1994 and the risk of long-dated derivatives. The case provides one of the best studies of taking an established product development /risk management policy for
derivatives into a new, uncertain environment. While the case is based during the mid-1990?s, the risk management template is still relevant today.
Study Questions:
1. How do the following apply in this case ? Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk ? which is the most important, meaning dangerous, risk in this case? It may be helpful to
consider a diagram of major markets and bank offices to see how these risks interact.
2. As an executive/ director based in New York, what concerns do you have about the operation in Mexico City? Weigh the challenges of control vs. business development between a head office and regional
outpost. Consider and comment on any added concerns an executive may have by also being a member of the Board of Directors.
3. How can Banc Zero assist a Mexican firm with U.S. Dollars loans in San Francisco but only Peso cash flow in Mexico? Consider Mexican and U.S. Dollar interest rates and exchange rates between, say,
January 1994 and December 31, 2004. Assume the loan in San Francisco is for $250 million and was used to build a factory near Mexico City.
4. How can Banc Zero?s derivatives initiative be helpful to solving the challenge faced by the Mexican firm in Question No. 3? Use David Ricardo?s basic trade theory to carefully explain your rationale ?
include diagrams.
5. Consider how a fall in the Mexican Peso ? where the value of the Peso moves from, say, $US 1.00 = 3.1057 on January 1, 1994 to $US 1.00 = 11.205 Pesos by December 31, 2004 affects the market
risk and credit risk positions of each of the participants in a 10-year cross-currency swap. Prepare a one-page Excel spreadsheet that uses the two-bond example developed in class for the seven-year Delphi
U.S. Dollar ? Euro cross-currency swap problem.
6. Draw a diagram showing the Mexican Peso/ U.S. Dollar cross-currency swap showing all flows and payments to the respective parties to the swap, including the underlying debt instruments. Use the interest
rate swap diagram discussed in class to help you structure the cross-currency swap. Assume that BancZero is a contractual counterpart to both sides of the currency swap. What is the mark-to-market
position at the end of Year 5 between the Mexican firm and Banc Zero? Who owes who, how much?
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