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Company X wishes to borrow US dollars at a fixed rate of interest. Company Y wishes to
Chapter 7, Problem 7.2(choose chapter or problem)
Company X wishes to borrow US dollars at a fixed rate of interest. Company Y wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies are subject to the following interest rates, which have been adjusted to reflect the impact of taxes:
\(\begin{array}{lrr} \hline & \text { Yen } & \text { Dollars } \\ \hline \text { Company X: } & 5.0 \% & 9.6 \% \\ \text { Company Y: } & 6.5 \% & 10.0 \% \\ \hline \end{array}\)
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.
Questions & Answers
QUESTION:
Company X wishes to borrow US dollars at a fixed rate of interest. Company Y wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies are subject to the following interest rates, which have been adjusted to reflect the impact of taxes:
\(\begin{array}{lrr} \hline & \text { Yen } & \text { Dollars } \\ \hline \text { Company X: } & 5.0 \% & 9.6 \% \\ \text { Company Y: } & 6.5 \% & 10.0 \% \\ \hline \end{array}\)
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.
Step 1 of 3
Foreign exchange risk can be defined as the risk that the cash inflows of a firm will reduce due to the change in foreign exchange rate. This is an additional risk which is faced by an MNC.
We know that Company X is willing to borrow in US dollars but if we see from the given interest rate, then Company X can borrow at a cheaper rate in Yen instead of dollars.
Similarly, while looking at Company Y, it is willing to borrow in terms of Yen but the rate at which Company Y can borrow in terms of Yen is more expensive than the rate at which Company X can borrow in terms of Yen.
So, both will engage in a swap.