Page 131 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes payments. Moreover, because a currency swap is not a loan, it does not appear as a liability on
the parties balance sheets.

Example: Company A, a British manufacturer, wishes to borrow US dollars at a fixed
rate of interest. Company B, a US multinational, wishes to borrow sterling at a fixed rate of
interest. They have been quoted the following rates per annum (adjusted for differential tax
effects).

Sterling US dollars
Company A 11.0% 7.0%
Company B 10.6% 6.2%
Design a swap that will net a bank, acting as intermediary, 10 basis points per annum and that
will produce equally gain per annum for each of the two companies.
Solution:
Company "A" wishes to borrow US dollars

Company "B" wishes to borrow Sterling
But Company B has competitive advantage in both (Sterling & US dollars).
In Sterling advantage is = (11.0 – 10.6) % = 0.4%
In US dollars advantage is = (7.0 – 6.2) % = 0.8%

So, Company B has competitive advantage in US$, but he wants to borrow Sterling.
Therefore B wants a counter party who has competitive advantage in sterling, but really wants
US dollars. So he gets Company A, both go for swap deal with the help of a financial institution.

For Company A:

Before the deal Company A gives 7% US $
But after the swap deal he gives 6.85% US $
So Gain for A=>(7 – 6.85)%=0.15% US $

For Company B:
Before the deal, company B gives 10.6% sterling
But after swap deal he gives 10.45% sterling
So Gain for B = (10.6 – 10.45) % = 0.15% sterling
For Financial Institution:

In US dollar gain = (6.85 – 6.2)%=0.65%

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