Question

2) Company A is based in UK and has a subsidiary in the US that requires funding in USD. It decides to enter into a currency swap agreement with company B in US. Company A will pay 5% on a Sterling principal of £10,000,000 and receive 6% on a US$ principal of $15,000,000 every year for the next 3 years. The current exchange rate is $1.5 USD per UK Sterling. Question: a) Explain and calculate the cash flow exchanges at the beginning, interim periods and at maturity.b) What are the potential advantages for company A in this swap?

Answer 1

a) cash flow exchanges at the beginning

at the beginning, Company A will give £10,000,000 to Company B and receive $15,000,000 from Company B.

cash flow exchanges at the interim periods

Company A will pay 5% on £10,000,000 every year for the next 3 years which will be £10,000,000*5% = £500,000‬

and will receive 6% on $15,000,000 every year for the next 3 years which will be $15,000,000*6% = $900,000‬.

Company B will receive £500,000‬ and pay $900,000 to Company A for the next 3 years.

cash flow exchanges at maturity

at the maturity, Company A will receive back £10,000,000 from Company B and return $15,000,000 to Company B.

b) As Company A is not a local company in US, so the borrowing cost of USD will be higher for it compared to the borrowing cost of a US company.

by entering into a swap, it can get USD funding at a lower rate than its borrowing cost in US and create savings in finance charges. in the swap, it's giving 5% but receiving 6%.

for example in year one, Company A paid £500,000 to Company B and received $900,000 from it.

assuming same spot exchange rate of $1.5/£, savings for Company A in dollar terms would be: $900,000 - £500,000*$1.5/£ = $900,000 - $750,000‬ = $150,000‬.