Question

• Suppose that Dow Chemical is looking to hedge some of its euro exposure by borrowing in euros. At the same time, Michelin (a French tire manufacturer) is seeking dollars to finance additional investment in the US. Both want the equivalent of $100m. Dow Chemical prefers to borrow floating rate euros, and Michelin fixed rate dollars. Dow Chemical can borrow floating rate at LIBOR + 0.4% vs Michelin ‘s cost of borrowing floating rate euros of LIBOR + 0.2%. Dow’s cost of borrowing dollars is 8% versus Michelin 8.5%. (Spot rate is $1.2/€)

1. What do you recommend the two companies to do in order to reduce the costs? Calculate the savings for each company in currency form (first answer for Dow and second for Michelin)
2. 2. Draw the diagram

Answer 1

Answer -

In order to reduce the costs of each two companies it is recommended to enter into interest rate swap, where the interest cost of both the companies would reduce keeping the preferences of both companies of floating ans fixed rate of interest. Here's how :

Following is the given situation:

	Dow Chemicals	Michelin
Home country	USA	France
Preferred rate	Floating	Fixed
Borrowing	€83.333m ($100m / 1.2)	$100m
Available € loan Floating rate	LIBOR + 0.4%	LIBOR + 0.2%
Available $ loan Fixed rate	8%	8.50%

Interest swap:

	Dow Chemicals	Michelin
Available rate	LIBOR + 0.4% (Floating)	8.50% (Fixed)
Rates after Interest Swap	LIBOR + 0.2% (Floating)	8%       (Fixed)

Interest rates can be swapped between Dow Chemicals and Michelin in such a way that Michelin transfer his available € loan Floating rate of LIBOR + 0.2% to Dow Chemicals and Dow Chemicals transfer his available $ loan Fixed rate of 8% to Michelin, then only it will reduce the interest cost of the two companies.

Statement showing savings for each company

	Dow Chemicals	Michelin
Savings in Interest rates after swap	0.2% [(LIBOR+0.4%) - (LIBOR+0.2%)]	0.5% (8.50% - 8%)
Borrowing	€83.333m ($100m / 1.2)	$100m
Savings in Amount	€0.1667m (€83.333m * 0.20%)	$0.50m       ($100m * 0.50%)