Question

You are a Chief Financial Officer in the US and you have the following situation:

1) Your Australia subsidiary has surplus funds in the amount of AUD 125M, the whole amount needs to be invested for 91 days. The investment rate in Australia at this time is 3.75% (annual) for this period

2) Your Italy subsidiary has a need for funds roughly equivalent to this amount at maturity, but needs the funds in EUR. The borrowing rate for the EUR sub is at 7.25% (annual)

3) The exchange rates are provided below for calculations.

		Bid	Ask
Spot Rate	EUR/USD	1.0875	1.0897
Forward (91 Day)	EUR/USD	1.0795	1.0802
		Bid	Ask
Spot Rate	USD/AUD	1.4345	1.4355
Forward (91 Day)	USD/AUD	1.4335	1.4344

Determine if there is an advantage to doing an FX swap for the company - use a 365-day basis for your calculations. Show your calculations in details.

Answer 1

A forex swap transaction (FX Swap) involves dealing in two different currencies for identical amounts involving purchase and sale with two different value dates (present and future).

In this problem, the australian subsidiary has AUD 125 mn excess fund which can be invested for an annual investment rate of 3.75%. The Italian subsidiary has roughly same funding requirement (EUR equiv. of AUD 125 mn) which can be borrowed at an annual interest rate of 7.25%. The amount is same and the tenure is same (91 days) but the currencies are different.

If the australian subsidiary, instead of investing for 91 days, lends it to Italian subsidiary, what would be the return at the end of 91 days. For this, cross-currency rates for EUR/AUD to be calculated based on the bid-ask rates provided for EUR/USD and USD/AUD. The bid-ask rates can be calculated for EUR/AUD by multiplying respective bid and rates of EUR/USD and USD/AUD. The table below gives the value:

		Bid	Ask
Spot Rate	EUR/USD	1.0875	1.0897
Forward (91 Day)	EUR/USD	1.0795	1.0802
Spot Rate	USD/AUD	1.4345	1.4355
Forward (91 Day)	USD/AUD	1.4335	1.4344
Spot Rate	EUR/AUD	1.5600	1.5643
Forward (91 Day)	EUR/AUD	1.5475	1.5494

Step 1:

Australian subsidiary lends AUD 125 mn to Italian subsidiary. But it needs in EUR, for which it sells AUD 125 mn and buy equiv. amount in EUR. Therefore, it sells AUD 125 mn and buys EUR at 1.5643 (Ask rate of EUR/AUD) = EUR 79.91 mn (125/1.5643)

Step 2:

After 91 days, Italian subsidiary returns the equivalent amount of EUR 79.91 mn back to Australian subsidiary. So it sells EUR 79.91 mn and buys equivalent AUD at 1.5475 (bid rate of EUR/AUD) = AUD 123.66 mn (79.91 x 1.5475).

For Australian subsidiary, its a loss of AUD 1.34 mn (125-123.66), for lending to Italian subsidiary and opportunity loss of AUD 1.17 mn (3.75% x 91/365 x 125)

For Italian subsidiary, it would have incurred an interest amount of EUR 1.44 mn (7.25% x 91/365 x 79.91).

For comparison, if EUR 1.44 mn is converted to AUD by multiplying with forward bid rate of EUR/AUD = EUR 1.44 mn x 1.5475 = AUD 2.24 mn, which is still lower than the aggregate of AUD 1.34 mn and AUD 1.17 mn. Hence, CFO should not enter in the said transaction.