Question

Question 8

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

The company receives Euros 45 million and it pays interest in dollars

Interest to be paid  = 45000000 * 3.5 % = 1575000 in Dollars

If the company invests in bonds that pays interest in Euro it can get 5% interest

interest in Euros= 45000000 * 5% = 2250000

At present the exchange rate is favorable as in euro terms as the interest to be paid by the co. works out to 1575000 *1.15= 1811250 euros which is less than 2250000 received by the co.

But to safeguard itself against future exchange rates risk the co can enter into currency swap in fixed rate of 4 % in dollars

and 4.75% in Euro.

The co. will receive @ 4% in dollars from the Bank and will pay 3.5% in dollars to the bondholders .

The co. will receive @ 5% in Euro from the Bonds and will pay 4.75% in Euros to the Bank .

Cash Flow Calculation:

	Receive		Pay
	Euro		Euro
45000000	5%		4.75%
	2250000		2137500
	Dollar		Dollar
	4%		3.50%
	1800000		1575000