Question

Two companies would like to borrow to take advantage of their comparative advantages and then swap. Both companies have positive NPV investments they will be making but would like to ensure they have the lowest cashflows out for their borrowings for that investment.

a) Yoshihiro wants to finance its American project in USD. Thomasina wants to finance its Japanese project in JPY. Here are the borrowing terms for each company USD rate JPY rate Yoshihiro( USD rate 9%) (jpy rate 4%) Thomasina(use rate 8%)(JPY rate 2% )

b) Which corporation is the most credit worthy? Why does it have an absolute advantage?

c) Which company has comparative advantage in the USD rate market? Why is this usually the case?

d) A Swap Dealer provides a swap offer. Yoshihiro will pay 7.6% in USD and will get 2% in JPY. Thomasina will pay 3.6% in JPY and receive 9% in USD. Evaluate the Swap for both companies. Will they accept this deal? What is unusual about this deal?

Answer 1

b) Thomasina is more credit worthy as it has lower borrowing rates in both USD and JPY. Thus banks consider Thomasima less risky and charge lower intrest rate as they are more ertain that they will get thier money back.

c) Thomasina has comparitive advantage in USD as it has a lower rate of intrest. This ususally happens when the company has operational history and credit history in the country of the bank. Here if Thomasina is raising money in USD from an US bank, then the ban will check if the company has any credit history or not. This gives banks added assurance that their money will not be at risk as there is some past credit history about the borrower.

d) The two companies will not go for this deal. For Yoshihiro does not have any comparitive advantage in any of the rates i.e USD or JPY as compared to Thomasina, Yoshihiro will borrow at 4% in JPY but only get 2%, thus loosing 2%, whereas it will only gain 1.4%(9%-7.6%). Similarly, Thomasina can borrow cheaper in JPY than the offer by swap dealer thus they will not go for this deal. What is unusual about this deal is that, the two companies are not gaining by lending in the currency which gives them favorable intrest rate (which is not the currency which they want) and borrowing in the curreny that they require. Thus this swap does not create value for both the parties and thus they will no go for it.

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