Question

Firm A is a U.S. MNC and wants to borrow €40 million for 3 years. Firm B is a French MNC and wants to borrow $60 million for 3 years. Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro. Firm B wants to finance a dollar denominated asset and therefore wants to borrow dollars. Firm A can borrow dollar at 7% or borrow euro at 6%. Firm B can borrow dollar at 8% or borrow euro at 5%. The current exchange rate is $1.50 = €1.00. If firms A and B knew and trusted each other, they could theoretically cut out the swap bank. Required: a) Develop a currency swap in which both firms A and B have equal cost saving. (40 marks) b) From the point of view of a corporate financial manager, discuss the basic motivations of using currency swap. (20 marks) c) Discuss the risks confronting an interest rate and currency swap dealer.

Answer 1

a) The currency swap should have the following arrangements,

1. Firm A should borrow $60 million in USA at 7% for 3 years

2. Firm B Should borrow 40 million Euros in Eurozone at 5% for 3 years.

3. Firm A and B enter into a Swap where Firm A receives 7% on $60 milllion every year from B and Pays 5% on 40 million Euros to B every year. At the end of 3 years, Firm A receives $60 million from B and pays 40 million Euros to B to close the swap.

In this way, Firm A and B both can achieve a synthetic loan in the currency they want and also have equal cost savings of 1% each (as compared to if they directly take loan)

b) The basic motivations to do a swap deal is to fulfill the strategic objectives of converting the nature of liabilities or assets from fixed rate to floating rate or from one currency to other. This swap deals help companies take advantage of each others competitive position and achieve the objective in a better way.

c) The interest rate dealer suffers from the currency risk. The dealer makes two way bids and has exposure in both the floating and fixed rate markets. These risks may not cancel each other out and the dealer's profits may be eroded.

Similarly, a currency swap dealer has exposure in different currencies and the relative movement between these currencies' exchange rate creates an exchange rate risk to the swap dealer.