Final answer:
The question deals with the impact of fluctuating interest rates on the value of a financial swap and the influence of interest rates on foreign exchange rates. The rates provided, such as SOFR, affect the fair value of a swap as determined by current market conditions. Additionally, higher interest rates can make a currency more attractive, impacting demand and supply and resulting in a new equilibrium exchange rate.
Step-by-step explanation:
Understanding Interest Rates and Exchange Rates
The student's question involves understanding how interest rates influence the exchange rates in the foreign exchange market and how a financial derivative, such as a swap, is valued over time as interest rates change. In the given scenario, the SOFR (Secured Overnight Financing Rate) serves as a basis for the floating settlement rates of the swap, and we see a change in rates at various intervals. The change in rates from 10% to 6% implies fluctuations in the value of the swap. Moreover, the example provided illustrates how a higher rate of return for U.S. dollars can shift demand and supply in the foreign exchange market, altering the exchange rate equilibrium.
The fair value of a swap is typically determined by comparing the present value of its expected future cash flows under current market conditions. The information provided from the Federal Reserve and derivatives dealers would be used to assess these values, considering real rates and risk premia. Note that the shortcut method mentioned in the question is an accounting technique used to simplify hedge accounting.