Question

BB can borrow in the United States for 9%, while AA has to pay 10% to borrow in the United States. AA can borrow in Australia for 7%, while BB has to pay 8% to borrow in Australia. BB will be doing business in Australia and needs AUD, while AA will be doing business in the United States and needs USD. The exchange rate is 2AUD/USD. AA needs USD1.0 million, and BB needs AUD2.0 million. They decide to borrow the funds locally and swap the borrowed funds. The swap period is for five years. Calculate the cash flows for this swap.

Answer 1

Both BB and AA each owe to their bank the annual interest payment:

AA borrows AU 2.0 million, with rate to pay the bank at 7%, or AUD 140,000 annually.

BB borrows USD 1.0 million, with rate to pay the bank at 9%, or U5D 90,000 annually.

AA and BB swap currencies:

AA gets USD 1.0 million, agreeing to pay BB at the rate of 10% interest in USD

BB gets AUD 2.0 million, agreeing to pay AA at the rate of 8% interest in AUD

Each other pay the annual interest:

AA owes BB USD 100,000 in interest and it has to be paid on each settlement date

BB owes AA AUD 160,000 in interest and it has to be paid on each settlement date

Both BB and AA owe their own bank the annual interest payment:

AA pays the Australian bank AUD 140,000 (whereas gets AUD160,000 from BB, an AUD 20,000 which is a gain)

BB pays the U.S. bank USD 90,000 (whereas gets USD 100,000 from AA, USD10,000 which is a gain)

Both the parties gained by swapping, where AA is ahead AUD20,000 and BB is ahead USD 10,000.

In five years, they reverse the swap. Notional principal will be returned:

AA will get AUD 2.0 million from BB and then it will pay back to the Australian bank.

BB will get USD 1.0 million from AA and then it will pay back to the U.S. bank.