Bank Canada has fixed-rate assets of $50 million funded by fixed-rate liabilities of 75 million Euros paying an interest rate of 10 percent annually. Bank Dresdner has fixed-rate assets of €75 million funded by fixed-rate liabilities of $50 million paying an interest rate of 10 percent annually. The current exchange rate is €1.50/$. They agree to swap interest payments on their liabilities to hedge against currency risk exposure for two years. At the end of the year, the exchange rate is €2/$. What are the losses and gains to each bank as a result of this swap compared to the scenario without the swap.

Question

Quizplus · Accepted Answer

Without the swap, Bank Dresdner would have to pay $5 million in interest on its liabilities (10% of $50 million), while Bank Canada would have to pay €7.5 million in interest on its liabilities (10% of €75 million). With the swap, Bank Dresdner pays €6.25 million in interest on its liabilities (10% of €50 million at the end of the year exchange rate of €2/$), while Bank Canada pays $8.75 million in interest on its liabilities (10% of $75 million at the end of the year exchange rate of €2/$). 
Therefore, Bank Dresdner saves €1.25 million ($2.5 million at the exchange rate of €2/$) by using the swap, but Bank Canada pays an additional $1.25 million in interest. So, the losses and gains are not equal for both banks, and the correct answer is A.

Bank Canada Has Fixed-Rate Assets of $50 Million Funded by Fixed-Rate