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

a).  Virgin would borrow £10 million for two years and Dell would borrow $16 million for two years. The two companies would then swap their proceeds and payment streams.

b).   Assuming no interest rate adjustments, Dell would pay 8.5% on the £10 million and Virgin would pay 7% on its $16 million. Given that its alternative was to borrow pounds at 9%, Dell would save 0.5% on its borrowings, or an annual savings of £50,000. Similarly, Virgin winds up paying an interest rate of 7% instead of 8% on its dollar borrowings, saving it 1% or $160,000 annually.

c). Ignoring credit risk differences, Virgin would have to provide Dell with 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% - x. then Virgin would have to borrow dollars from Dell at 8.75% - (0.5% + x) to cover the 0.5% + x difference between the interest rate at which it was borrowing pounds and the interest rate at which it was lending those pounds to Dell.