Question

In: Finance

Firm ABC is a UK based retailer and Firm XYZ is an Italian manufacturer. Firm ABC...

Firm ABC is a UK based retailer and Firm XYZ is an Italian manufacturer.

Firm ABC is planning to open a number of retail stores in France and wants to borrow €60 million for 4 years to fund this.

Firm XYZ has an opportunity to acquire a competitor located in the UK and wishes to borrow ₤50 million for 4 years to fund this acquisition.

The current spot FX rate is S(EUR/GBP)=1.20. The annual borrowing rates available to the firms by issuing four year fixed rate bonds are below:

Euro Borrowing Rate Pound Borrowing Rate
ABC 4.3% 5.2%
XYZ 4.0% 5.5%

B2 (b) Suppose that ABC and XYZ both decide to enter into a fixed-for-fixed cross currency swap. Imagine you are a swap bank intermediating between the two firms. You are asked to design a fixed-for-fixed cross currency swap for each firm with the following features:

  • Both firms achieve their desired borrowing with no additional FX exposure.
  • The annual interest savings by both firms relative to borrowing directly are equal.
  • The swap bank profit (on an annual basis) is equal to the interest savings by the firms.

Find the bid and ask rates that the swap bank provides for both € and ₤ that generate these features and calculate the savings or profits of all parties.

B2 (b) Now suppose that the two firms instead entered into a direct fixed-for-fixed cross-currency interest rate swap with each other. This swap has the following features:

  • ABC pays 4.0% on EUR 60 million over 4 years to XYZ
  • XYZ pays 5.2% on GBP 50 million over 4 years to ABC
  • The firms exchange principals as part of this swap
  • The value of the swap is zero at inception.

In one year's time, the market swap rates are 4.1% for the Euro payments, and 5.4% for the Pound payments. The exchange rate in one year's time is S(EUR/GBP)=1.25. Calculate the new value of the swap. Which party would be required to compensate the other in order to terminate the swap?

Solutions

Expert Solution

ABC wants to borrow 60 million Euros and XYZ wants to borrow 50 million pounds or (50*1.2 =60 million Euros) . So, both the companies want to borrow the same amount in different currencies

A look at the borrowing rates available indicates that ABC can borrow cheaply in pounds and XYZ can borrow cheaply in Euros by 0.3%. So, the total advantage they have is 0.3%+0.3% = 0.6%

Since they want to borrow in opposite currencies where the other company has advantage, they can borrow in their own currency (ABC in pounds and XYZ in Euros) and then arrange a swap to get the required borrowing.

Since the total advantage of 0.6% is to be split in 3 parties ABC, XYZ and swap bank, each will get a benefit of 0.2%

The terms of the swap of ABC with the bank : ABC will pay 4.1% in Euros to Swap bank and receive 5.2% in pounds (Notional principal = 50 million pounds or 60 million Euros), Thus , on a net basis, ABC is paying 4.1% in Euros thereby benefitting by 0.2% than the direct borrowing rate available.

The terms of the swap of XYZ with the bank : XYZ will pay 5.3% in pounds to Swap bank and receive 4% in Euros (Notional principal = 50 million pounds or 60 million Euros).Thus , on a net basis, YZ is paying 5.3% in pounds thereby benefitting by 0.2% than the direct borrowing rate available.

The intermediary will gain 0.1% in pounds and 0.1% in Euros totalling a benefit of 0.2%

Swap banks Euro rates are 4.0% - 4.1% (bid-ask)

and pound rates are 5.2% - 5.3% (bid-ask)

b) The swap can be valued in terms of Euro and Pound bonds

Value of Euro bond (million Euros) = 2.4 /1.041 + 2.4/1.041^2+62.4/1.041^3 = 59.83381 million Euros

Value of pound bond (million pounds) = 2.6 /1.054 + 2.6/1.054^2+52.6/1.054^3 = 49.7297 million pounds

Value of swap to ABC (in million Euros) = Value of pound bond received * exchange rate - value of Euro bond paid

= 49.7297 *1.25 - 59.83381

= 2.3283 million Euros

As the value of Swap is positive for ABC , XYZ has to pay 2.3283 million Euros to ABC to terminate the swap.


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