Question

Consider fixed-for-fixed currency swap. Firm A is a U.S.-based multinational. Firm B is a U.K.-based multinational. Firm A wants to finance a £2 million expansion in Great Britain. Firm B wants to finance a $4 million expansion in the U.S. The spot exchange rate is £1.00 = $2.00. Firm A can borrow dollars at 10 percent and pounds sterling at 12 percent. Firm B can borrow dollars at 9 percent and pounds sterling at 11 percent. Which of the following swaps is mutually beneficial to each party and meets their financing needs? Neither party should face exchange rate risk.

1. There is no mutually beneficial swap that has neither party facing exchange rate risk.

2. Firm A should borrow $4 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 2 million pounds and pays 8 percent in dollars to A.

3. Firm A should borrow $2 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 4 million pounds and pays 8 percent in dollars to A.

4. Firm A should borrow $4 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 2 million pounds and pays 10 percent in dollars to A.

Answer 1

Answer is 1. There is no mutually beneficial swap that has neither party facing exchange rate risk.

Exchange rate is £1.00 = $2.00. Both currencies are not equal in per unit. So, there will be always exchange rate risk to other party in this case Firm A.

Option 2 is not beneficial because firm A pays more to firm B than what it receives from firm B.

Firm A pays = ($4,000,000/$2) = £2,000,000*11% = £220,000

Firm B pays = (£2,000,000*$2) = $4,000,000*8% = $320,000

Now if we convert $320,000 paid by firm B to firm A in to pounds then it comes to $320,000/$2 = £160,000. so, Firm A paid £220,000 but received only £160,000. this discrepancy is due to exchange rate.

Option 3 is not beneficial because firm B pays more to firm A than what it receives from firm A.

Firm A pays = ($2,000,000/$2) = £1,000,000*11% = £110,000

Firm B pays = (£4,000,000*$2) = $8,000,000*8% = $640,000

Now if we convert $640,000 paid by firm B to firm A in to pounds then it comes to $640,000/$2 = £320,000. so, Firm A paid only £110,000 but received more £320,000. this discrepancy is due to exchange rate.

Option 4 is not beneficial because firm B pays more to firm A than what it receives from firm A.

Firm A pays = ($4,000,000/$2) = £2,000,000*11% = £220,000

Firm B pays = (£2,000,000*$2) = $4,000,000*10% = $400,000

Now if we convert $400,000 paid by firm B to firm A in to pounds then it comes to $400,000/$2 = £200,000. so, Firm A paid £220,000 but received only £200,000. this discrepancy is due to exchange rate.