1.(a) Discuss the basic motivations for a counterparty to enter into a currency

Question

1.(a) Discuss the basic motivations for a counterparty to enter into a currency swap. (20 pts)

2.Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assume that a swap bank is involved as an intermediary and the bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.

            Alpha and Beta Companies can borrow for a five-year term at the following rates:

                                                Alpha              Beta

                                    Moody’s credit rating                         Aa                   Baa

                                    Fixed-rate borrowing cost                   10.5%              12.0%

                                    Floating-rate borrowing cost               LIBOR            LIBOR + 1%

(a)Calculate the quality spread differential (QSD). (10 pts)

(b)Graph the swap including the external financing costs. (20 pts)

(c) What is the all-in interest rate cost for each of the firms? (20 pts; 10 pts for each firm)

(d) How much does the swap bank make (in terms of interest rates)? (10 pts)

(e) How much does each firm save per year? (10 pts)

(f) Assume Alpha and Beta want to borrow $ 100,000,000 for 5 years. Further, the LIBOR rate over the next 5 years is expected to be 7%. Report the net borrowing costs (in dollar terms, not interest rates) for both parties. (10 pts)

Explanation / Answer

Since, multiple questions have been posted, I have answered the first one.

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Question 1)

The basic motivation for a counterparty to enter into a current swap is to obtain lending (in foreign currency) at a lower rate of interest. It is possible because of the comparative advantage of the local party to obtain/borrow money at a lower interest rate from the domestic market when compared with a party (borrower) situated/located in some other country. The local party can thereafter lend the money (so borrowed) at a lower rate of interest to the counterparty. For Instance, an Indian company planning to expand operations in USA may enter into a currency swap with a US based company planning to enter India. In this case, the US company can borrow dollars and lend the money to Indian company at the same rate of interest at which it borrowed money. Similarly, the Indian company can borrow money in local currency (rupees) and lend it to the US company. If the Indian company had tried to borrow money in US dollars, it could have obtained the same at higher interest rates. The same situation would apply to the US company. Therefore, the currency swap helps in reducing the cost of capital for the parties entering into currency swap.

Another possible advantage of currency swap available to the counterparty is the ability to reduce the risk associated with exchange rate fluctuations.This is possible as debt repayments (in foriegn currency) get made at a predetermined exchange rate which gets locked at the time of entering into the currency swap. Thus, long term exchange rates remain fixed under currency swap for the parties to the swap.

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