Question

Consider a company that issues a dual-currency bond with a face value of €45 million, which pays an interest rate of 3.5 percent a year in dollars. Indicate how the company can manage the risk on this bond issue and calculate the net cash flows associated with the transactions. A bond with a face value of €45 million that pays 5 percent annual interest in euros is available for purchase. The fixed rates on a currency swap are 4 percent in dollars and 4.75 percent in euros, and the exchange rate is €1.15/$.

Answer 1

Company will issue dual-currency bond with a face value of €45 million or equivalent of €45/1.15 = $39.13 million and will pay 3.5% interest in dollars.

Company purchases bond with a face value of €45 million that pays 5 percent annual interest in euros with €45 million received by issuing dual-currency bond. also company enters into a currency swap for hedging the risk on bond issue by receiving 4 percent in dollars on $39.13 million and paying 4.75 percent in euros on €45 million.

Company pays interest in dollars on dual-currency bond = (€45,000,000/€1.15/$)*3.5% = $39,130,435*3.5% = $1,369,565

Company receives interest on bond purchased = €45,000,000*5% = €2,250,000

Company receives interest in dollars from currency swap = (€45,000,000/€1.15/$)*4% = $39,130,435*4% = $1,565,217

Company pays interest in euros to currency swap = €45,000,000*4.75% = €2,137,500

Net cash flow in dollars = interest received in dollars from currency swap - interest paid in dollars on dual-currency bond

Net cash flow in dollars = $1,565,217 - $1,369,565 = $195,652

Net cash flow in euros = interest received in euros from bond purchased - interest paid in euros to currency swap

Net cash flow in euros = €2,250,000 - €2,137,500 = €112,500

Total net cash flow or profit in dollars = $195,652 + €112,500/€1.15/$ = $195,652 + $97,826 = $293,478

Total net cash flow or profit in euros = €112,500 + $195,652*€1.15/$ = €112,500 + €225,000 = €337,500