Dow Chemical, a US-based firm, seeks to hedge most of the exposure of its European operations...

Dow Chemical, a US-based firm, seeks to hedge most of the exposure of its European operations by borrowing in Swiss francs (CHF). At the same time the French tire manufacturer Michelin is seeking US dollars to finance additional investment in its US manufacturing plants. Both firms want the equivalent of $150 million US dollars in fixed-rate financing for 10 years. Dow can issue dollar-denominated debt at an interest rate of 7.5 percent per year, or Swiss franc denominated debt at a rate of 8.25% per year. Equivalent rates for Michelin are 7.8% per year in US dollars and 8.1% per year in Swiss francs. The current spot rate is 1.13 USD/CHF. A bank is willing to arrange 10-year currency swaps with its clients at the following rates: the bank is willing to pay to (receive from) clients US dollars at 7.6% p.a. (7.7% p.a.), and pay to (receive from) Swiss francs at 8.25% p.a. (8.3% p.a.).

(a) Suggest how Dow Chemical can use a swap to achieve its objective of reducing the currency risk from its European operations while still obtaining the lowest cost of funding. Outline the cash flows for the swap.

(b) Based on the swap you proposed, what is the all-in cost of financing for Dow? Show your calculations.

Expert Solution

USD/CHF$150/1.13=$132.74

A)

DOW Chemical(mm)
Year	1	2	3	4	5	6	7	8	9	10
Issue USD 150(mm)	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00
earn Interst of USD 7.5% of Loan issued on USD $150	11.25	11.25	11.25	11.25	11.25	11.25	11.25	11.25	11.25	11.25
Buy Swiss from bank of $150(mm) Equ of USD $132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74
Pay Interst of Swiss of 8.3% to Bank	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02
Profit (Interest earn - Interest Paid)(11.25-11.02=0.23)	0.23	0.23	0.23	0.23	0.23	0.23	0.23	0.23	0.23	0.23

B)

Michelin
Year	1	2	3	4	5	6	7	8	9	10
USD	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00	150.00
EUR	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74	132.74
Earn Interest on EUR	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02	11.02
Pay on US Dollar	11.55	11.55	11.55	11.55	11.55	11.55	11.55	11.55	11.55	11.55
Extra Cost	-0.53	-0.53	-0.53	-0.53	-0.53	-0.53	-0.53	-0.53	-0.53	-0.53

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