Question

In: Finance

PLEASE NOTE: THE QUESTION HAS BEEN POSTED BEFORE. I WOULD LIKE A FRESH TAKE ON IT...

PLEASE NOTE: THE QUESTION HAS BEEN POSTED BEFORE. I WOULD LIKE A FRESH TAKE ON IT AS THE PREVIOUS ANSWER WAS NOT CLEAR ENOUGH. HERE IS THE QUESTION:

Give an example to explain why a US company might wish to enter into a fixed rate currency swap, paying Euros and receiving fixed- rate Sterling.

Solutions

Expert Solution

One scenario which I can think of:

  • Imagine a US automobile which has operations in three countries: US (revenues in USD), UK (revenues in GBP) and Germany (revenues in EUR).
  • Revenue Split is 40% from the US, 30% from Germany and 30% from UK.
  • The company has two production facilities; one in the US and one in Germany.
  • US facility produces exclusively and entirely for the US market while UK and German markets are served by the German facility.
  • Hence, for the US business, both revenues and costs are denominated in USD. Hence there is no exchange rate risk here.
  • For the European business, costs are entirely in EUR while revenues are split revenues are half in GBP and half in EUR.
  • Thus in the European business, I have an exchange rate risk towards the GBP
  • In case the GBP were to depreciate (eg. No deal Brexit plays out), my costs being denominated in EUR would remain stable, albeit my revenues denominated in GBP would go down.
  • It would hence be prudent for me to convert my GBP exposure to EUR as I have a natural hedge there in terms of production costs.
  • In that case, I would want to buy a fixed rate currency swap receiving Sterling and paying floating EUR.
  • This would be cheaper option compared to hedging both GBP and EUR exposure against the USD because of the natural hedge.

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