U is a U.S.-based MNC with AAA credit; I is an Italian firm with AAA credit. Fir
ID: 2721746 • Letter: U
Question
U is a U.S.-based MNC with AAA credit; I is an Italian firm with AAA credit. Firm U wants to borrow €1,000,000 for two years and I wants to borrow $1,100,000 for two years. The spot exchange rate is 1.10$/€, a swap bank makes the following quotes for 2-year swaps and AAArated firms against USD LIBOR: USD EUR Bid Ask Bid Ask 2% 2.1% 1.5% 1.6% The firms’ external borrowing opportunities are: Euro Borrowing USD Borrowing I €1.5% $2.5% U €2.0% $2% You represent the swap bank.
a. Calculate the QSD and show the firms that there exists an advantage to swap.
b. Lay out the exact proposal for the swaps for the two firms. That is advise them on their borrowing decision and their swap contracts.
c. Calculate the absolute benefit denominated in USD to firms U & I and the swap bank.
d. A fresh MBA claims that the US firm should be indifferent between borrowing at the Euro rate of 2% or the USD rate of 2%. Comment.
Explanation / Answer
Answer
Answer (a), (b) & (c)
Currency
U (U.S. Based MNC)
I (Italian Firm)
Gain
Euro
2%
1.50%
0.50%
USD
2%
2.50%
0.50%
Total swap Gain
1.00%
Swap bank will Ask U (US based MNC) to borrow $1,100,000 @ 2%. Then Swap Bank will take $1,100,000 from U (US based MNC) and will lend $1,100,000 to I (Italian Based firm) @ 2.1%. So Swap bank will gain 0.1% (2.1% -2%) and I (Italian firm) will gain 0.4% (2.5% - 2.1%) on $1,100,000.
Swap bank will Ask I (Italian Firm) to borrow €1,000,000 @ 1.5%. The Swap bank will take €1,000,000 from I (Italian Firm) and will lend €1,000,000 to U (US based MNC) @ 1.6%. So Swap bank will gain 0.1% (1.6% - 1.5%) and US based MNC will gain 0.4% (2.0% - 1.6%) on €1,000,000.
Particulars
Swap Gain
Amount
Absolute gain in USD
A
B
Swap Bank
A*B
USD
(2.1% -2%)
0.10%
1100000
1100
Euro
(1.6%-1.5%)
0.10%
1100000
1100
0.20%
2200
U (US based MNC)
(1% - 0.2%)/2
0.40%
1100000
4400
I (Italian Firm)
(1% - 0.2%)/2
0.40%
1100000
4400
Total Swap Bank
1.00%
11000
Answer (d)
A fresh MBA claims that the US firm should be indifferent between borrowing at the Euro rate of 2% or the USD rate of 2%. Comment.
The spot exchange rate is 1.10$/€.
If US firm borrows at Euro rate of 2%, then
Interest cost = €1,000,000 *0.02
=€ 20,000
= $ 22000 (€ 20,000 * 1.10)
If US firm borrows at USD rate of 2%, then
Interest cost = USD $1,100,000 * 0.02
= $ 22,000
So Interest cost remains same in both options So the US firm should be indifferent between borrowing at the Euro rate of 2% or the USD rate of 2% Provided exchange rate of 1.10$/€ will remain same throughout borrowing period.
Currency
U (U.S. Based MNC)
I (Italian Firm)
Gain
Euro
2%
1.50%
0.50%
USD
2%
2.50%
0.50%
Total swap Gain
1.00%
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