Question

Red Balloons Ltd, a Canadian supplier of military radar equipment, has just won a bid to lease the Spanish Air Force some high-end sensors for the next ten years.  The first of 20 semi-annual payments of €5.3 million will be made on January 1, 2013.

1. Assuming Red Balloons will need to convert Euros into dollars before they can pay their expenses, does this contract provide them with a long or short exposure to the Canadian Dollar?  Explain.

To manage their risk, Red Balloons contacted the swap desk at their bank who offered to buy their foreign currency every six months for a rate of $1.2585 CAD per Euro for the length of the contract.

2. If Red Balloons accepts the offer, will the bank have a long or short exposure to Euro as a result of this new contract?  Explain with a diagram showing both transactions between the three parties
3. When banks take on these kinds of currency risks and enable their clients to hedge, they neutralize their own exposures by swapping the foreign currency to banks domiciled in the originating country.  If the Canadian bank needs to make a present value of $465,000 from arranging this swap to cover their costs, and the appropriate semi-annual discount rate is 2%, what is the lowest price in dollars that the Canadian bank can accept for the Euros they will resell? Keep 4 decimal places.
4. In the case of cross-currency swaps like this, the entire amounts are exchanged each time, not simply a net payment.  Explain why this is.  

Answer 1

a. The company first pays Canadian dollars towards its expenses, then it sells its goods and gets Euros in return. This is equivalent to selling Canadian dollars in return of Euros. So essentially this sales contract provides them with a short exposure to the Canadian Dollar.

a2. As a result of this new contract, the bank will have long exposure to the Euro. This is because the bank has agreed to take delivery of the Euros and its profit or loss will be directly proportional to the rise or fall in the value of Euro. The diagram below shows these transactions between the parties:

Part b.

To calculate this, we can consider the given NPV to be the present value of an annuity of semi-annual payments whose present value at 2% semi-annual rate should be 465,000. We can calculate the fixed payment of this annuity using the formula for PV of an annuity or we can use the PMT function of Excel or calculator as shown below:

-PMT (Rate, number of payments, Present value)

So the bank should get a profit of 28,437.87 Dollars every 6 months. The Dollars that they will pay to Red ballons will be

Thus the lowest price is 1.2531 Dollar per Euro

Part c.

The entire amounts are exchanged because if it is not done in this way and only the net difference (profit or loss) from the respective position is settled, the parties will still be left with the foreign currencies that they do not need or do not want to hold. For example, in this case, if the Canadian bank does not exchange the full payment of 5.3 million Euros every 6 months and only decides to settle the change in exchange rate with respect to initial rate, it will be left with so many Euros and the foreign currency risk will still remain with it as the fluctuations in the value of the Euro will affect the value of its assets. So the entire amounts are exchanged each time.

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