Question

Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies have been quoted the following interest rates, which have been adjusted for the impact of taxes. Let's assume both companies X and Y entered into a SWAP contract with a bank B that requires 25 basis points per contract as fee. In total, how much interest rate would company X, Y pay and in what currency?

	YEN	DOLLARS
COMPANY X	5.0%	9.6%
COMPANY Y	6.5%	10.0%

Answer 1

	YEN	DOLLARS
COMPANY X	5.0%	9.6%
COMPANY Y	6.5%	10.0%

• Company X having Advantages When Borrowing in Yen.
• Company Y having Advantages When Borrowing in Dollars.

• Step 1 :

Differential in Yen Interest Rate = Difference Between Yen Borrowing Interest Rate of COMPANY X & COMPANY Y

= 6.5% - 5.0% = 1.5%

• Step 2 :

Differential in Dollar Interest Rate = Difference Between Dollar Borrowing Interest Rate of COMPANY X & COMPANY Y = 10.0% - 9.6% = 0.4%

• Step 3 :

Gain on Swap of All Parties from SWAP Agreement :

Difference of Differential in Dollar & Yen  Interest Rate = 1.5% - 0.4% = 1.1%

• Step 4 :

Benefits of SWAP Provider = 0.25%

Total Benefit of X & Y = Difference of Differential in Dollar & Yen Interest Rate - Benefits of SWAP Provider

= 1.1% - 0.25% = 0.85%

Profit For Each Parties = 0.85% / 02 = 0.425%

Now Company X will Borrow in Yen @ 5.0% and Same will provide to SWAP Agreement with Bank

Now Company Y will Borrow in Dollar @ 10.0% and Same will provide SWAP Agreement with Bank

• Step 5 :

Effective Rate of Japanese Yen for Y will be (Ans)

= Yen Borrowing Rate for Y -  Profit For Each Parties = 6.5% -  0.425% = 6.075%

Effective Rate of Dollar for X  will be (Ans)

= Dollar Borrowing Rate for X - Profit For Each Parties =9.6% - 0.425% = 9.175%