Question

Dell Computers would like to borrow pounds, and Virgin Airlines wants to borrow dollars. Because Dell is better known in the United States, it can borrow on its own dollars at 7 percent and pounds at 9 percent, whereas Virgin can on its own borrow dollars at 8 percent and pounds at 8.5%

a. Suppose Dell wants to borrow £10 million for two years, Virgin wants to borrow $16 million for two years, and the current ($/£) exchange rate is $1.60. What swap transaction would accomplish this objective? Assume the counterparties would exchange principal and interest payments with no rate adjustments.

b. What savings are realized by Dell and Virgin?

c. Suppose, in fact, that Dell can borrow dollars at 7 percent and pounds at 9 percent, whereas Virgin can borrow dollars at 8.75 percent and pounds at 9.5 percent. What range of interest rates would make this swap attractive to both parties?

d. Based on the scenario in part (c), suppose Dell borrows dollars at 7 percent and Virgin borrows pounds at 9.5 percent. If the parties swap their current proceeds, with Dell paying 8.75 percent to Virgin for pounds and Virgin paying 7.75 percent to Dell for dollars, what are the cost savings to each party?

Answer 1

Question a:

	USD	GBP	Prefers
Dell	7	9	GBP
Virgin Airlines	8	8.5	USD

In a swap transaction Party A will have a comparative advantage in one currency and Party B will have an advantage in the other currency. In this case Dell has an comparative advantage in USD borrowing rate & Virgin has an advantage in GBP borrowing rate.

Also note that based on the credit ratings of the company the borrowing rate will differ attracting parties for a swap transaction.

To answer the question, this swap transaction will make Dell to borrow $16 million (where it has an advantage) and Virgin to borrow £10 million for 2 years. Then they enter into a swap agreement to exchange their cash flows to get their preferred currency rates with an interest rate mutually benefitting both the parties.

The Swap transaction is summarized below.

Question b:

As shown in the Figure above.

• Dell --> Pays GBP rate @ 8.5% on the £10 million
• Virgin --> Pays USD rate @ 7% on the $ 16 million

Savings:

Dell savings = Rate @ which it would have borrowed without Swap transaction - Rate post Swap transaction

= 9% - 8.5% (no rate adjustments)

= 0.5% on its borrowings or an annual savings of £50,000 (0.5% of £10 million)

Virgin savings = Rate @ which it would have borrowed without Swap transaction - Rate post Swap transaction

= 8% - 7%

= 1% on its USD borrowing or an annual savings of $ 160,000 (1% of $16 million)

Question C:

	USD	GBP	Prefers
Dell	7	9	GBP
Virgin Airlines	8.75	9.5	USD

As Dell prefers Pound borrowing, Virgin should deliver a pound rate of less than 9%.Given that Virgin has to borrow the pounds at 9.5%, it would have to save at least 0.5% on its dollar borrowing from Dell to make the swap worthwhile.

If Dell borrows pounds from Virgin at 9% - i. then Virgin would have to borrow dollars from Dell at 8.75% - (0.5% + i) to cover the (0.5% + i ) difference between the interest rate at which it was borrowing pounds and the interest rate at which it was lending those pounds to Dell.

Question D:

Dell savings (pounds) = 9% - 8.75% = 0.25% on Pounds

Dell savings (dollars) = 7.75% - 7% = 0.75% on Dollars

Total Dell savings = 1%

Virgin savings (pounds) = 8.75% - 9.5% = - 0.75% on pounds

Virgin savings (dollars) = 8.75% - 7.75% = 1% on dollars

Total Virgin savings = 0.25%

Hit thumbsup if you find this useful