7.3. Company X wishes to borrow U.S. dollars at a fixed rate of interest. Compan

Question

7.3. Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y wishe to borrow Japanese yen at a fixed rate of interest. The amounts required by the tw companies are roughly the same at the current exchange rate. The companies have beci quoted the following interest rates, which have been adjusted for the impact of taxes: Yen CompanyX Company Y 5.0% 6.5% Dollars 9.6% 10.0% Design a swap that will net a bank, acting as intermediary, 50 basis points per annut Make the swap equally attractive to the two companies and ensure that all foreig exchange risk is assumed by the bank

Explanation / Answer

Solution:

Creatung a swap contract

Company X can borrow Yen at 5% and dollar at 9.6%

Company Y can borrow Yen at 6.5% and dollar at 10%.

Company X has absolute advantage as rates are lower for them. While Company Y has Comparative advantage for dollars because if we see the difference of dollar rate then it is 10-9.6 = .4%.

Similarly for Yen the difference is 6.5% -5% = 1.5%

So if company X borrows Yen and company Y borrows Dollars then both company will be benefitted after SWAP

Total gain for both the company = Difference in Yen Rate- Difference in dollar rate - Bank intermediary

=1.5% -0.4% -0.5% = 0.6%

So 0.6% gain will be equally distributed among both company.

Effective borrowing rate after swap For company X : 9.6% - 0.6%/2 = 9.3%

Effective borrowing rate after swap For company Y : 6.5% - 0.6%/2 = 6.2%

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