Question

Firm X wishes to borrow U.S. dollars at a fixed rate of interest. Firm Y wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies have been quoted the following interest rates, which have been adjusted for the impact of taxes:

	JPY	USD
Firm X:	5.0%	9.6%
Firm Y:	6.5%	10.0%

1. Which company has a comparative advantage in borrowing JPY and in borrowing USD?
2. Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally attractive to the two companies with all foreign exchange risk being assumed by the bank. Show your calculations as you illustrate the transaction.

Answer 1

The situation is presented in table below

	JPY	USD
Firm X	5%	9.60%
Firm Y	6.50%	10%
Advantage	1.50%	0.400%
Gain from Swap	1.100%

Firm X has absolute advantage in borrowing in both currencies as it can borrow cheaply in both currencies as compared to Firm Y. However, its advantage over Y is much more in Borrowing in JPY (1.5%) as compared to borrowing in USD (0.4%)

Hence, Firm X has comparative advantage in borrowing in JPY and Firm Y has comparative advantage in borrowing in USD

As Firm X wants to borrow in USD and Firm Y wants to borrow roughly the same amount in JPY, both can benefit by borrowing in the currencies of their comparative advantage and then undergoing a swap.The following are steps to design the swap. In all the transactions, the principal amount remains the same.

1. Firm X borrows in JPY at 5% and Firm Y borrows in USD at 10%

2. Firm X and the Bank agree to exchange cashflows where the Firm X pays interest on Principal at 9.3% in USD and receives interest on the same principal at 5% in JPY, thus effectively borrowing USD at 9.3% (benefit of 0.3%)

3. Firm Y and the Bank agree to exchange cashflows where the Firm Y pays interest on Principal at 6.2% in JPY and receives interest on the same principal at 10% in USD, thus effectively borrowing JPY at 6.2% (benefit of 0.3%)

4. The Bank pays 5% in JPY to X and receives 6.2% in JPY from Y , thus receiving net 1.2% in JPY.

The Bank pays 10% in USD to Y and receives 9.3% in USD from X , thus paying net 0.7% in USD.

Thus the bank is effectively benefitting by 0.50% (and assumes all foreign exchange risk)

and the Swap is equally attractive to both firms X and Y as their benefit (0.3%) is same