Question

A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates €30,000,000 a year, received in equivalent semiannual installments of €15,000,000. The British company wishes to convert the euro cash flows to pounds twice a year. It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds. The current exchange rate is €1.1227/£. The fixed rate on a plain vanilla currency swap in pounds is 5.0 percent per year, and the fixed rate on a plain vanilla currency swap in euros is 6.0 percent per year.

a. Determine the notional principals in euros and pounds for a swap with semiannual payments that will help achieve the objective.

b. Determine the semiannual cash flows from this swap.

Answer 1

Given currency exchange rate = €1.1227/£

fixed rate on currency swap in euros = 6%

fixed rate on currency swap in pounds = 5%

conversion done twice a year

a.

The semiannual cash flow that must be converted into pounds is €30,000,000/2 = €15,000,000.

Now, we need to create a swap to convert €15,000,000

For this, the notional principals are as follows

Euro notional principal = amount to be converted/ (fixed rate on currency swap in euros/2)

Note: division by 2 is considered because conversion is done twice an year

Euro notional principal = €15,000,000/(0.06/2) = €500,000,000

Pound notional principal = Euro notional principal/ currency exchange rate

Pound notional principal = €500,000,000/ 1.1227/£ = £445,354,948

b.

Semi-annual cash flows are

Swap payment made by the company = Euro notional principal * (fixed rate on currency swap in euros/2) = €500,000,000 * (0.06/2) = €15,000,000

Swap payment received by the company = Pound notional principal * (fixed rate on currency swap in pounds/2) = £445,354,948 (0.05/2) = £911,133,874

Note: Answers rounded off to nearest integer