John was learning about currency swap agreements. John was confused why would co
ID: 2801087 • Letter: J
Question
John was learning about currency swap agreements. John was confused why would company A agree to such a swap agreement. If we take a look at the interest rate offered to both companies from the market:
Borrow U.S. Dollar
Borrow British Pound
Company A
8%
11.6%
Company B
10%
12%
Based on the market offer, company A has the comparative advantage of borrowing U.S. dollar, and company B has the comparative advantage of borrowing British pound (it is intuitive since company A is headquartered in U.S. and company B is headquartered in U.K.). However, company A wants British pound for its U.K. expansion, while company B wants U.S. dollar for its U.S. expansion.
The swap agreement: company A borrows U.S. dollar at 8% from the market, and company B borrows British pound at 12% from the market. Then they sit down and do the swap. After the swap, A pays net 11% on the British pound, and B pays net 9.4% on U.S. dollar.
The problem is, it looks like company B is completely ripping company A off!
John’s question was, why doesn’t company A just borrow U.S. dollar and exchange it to British pound to fund its business? This way, company A only pays 8% interest on U.S. dollar. Why on earth would company A agree to such a swap and eventually pay 11% interest on the British pound, even though 11% interest rate on British pound is 0.6% lower than the U.K. market offers? Why on earth would company A ever want to pay interest based on U.K. market rate which is much higher than the rate in U.S. market?
Borrow U.S. Dollar
Borrow British Pound
Company A
8%
11.6%
Company B
10%
12%
Explanation / Answer
Now, since by entering into a swap, A is getting the British pound loan at 11% which is at 0.6% advantage than directly taking loan of 11.6%.
But the question arises that when A can borrow US dollar loan at 8%, why not do it and exchange for British pound loan. This is because of fluctuations in exchange rate. There would be a huge risk, converting the British pound to US dollars. A fluctuation increase the net interest payment to even 12% or more. So, to hedge the risk of interest payments, the swap agreement should be chosen.
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