Consider the dollar- and euro-based borrowing opportunities of companies A and B. $\begin{array}{ccc}
& € \text { borrowing } & \$ \text { borrowing } \
\mathrm{A} & € 7 \% & \$ 8 \% \
\mathrm{~B} & € 6 \% & \$ 9 \%
\end{array}$ A is a U.S.-based MNC with AAA credit; B is an Italian firm with AAA credit.Firm A wants to borrow €1,000,000 for one year and B wants to borrow $2,000,000 for one year.The spot exchange rate is $2.00 = €1.00 and the one-year forward rate is given by IRP as $\frac { \$ 2.00 \times ( 1.08 ) } { € 1.00 \times ( 1.06 ) }$ = $\frac { \$ 2.0377 } { € 1.00 }$ .
Suppose they agree to the swap shown here.Is this mutually beneficial swap equally fair to both parties?
A)Yes,QSD = [€7% ? €6% × $2.00/€1.00] ? ($8% ? $9%)= $2% + $1% = $3%.
B)No,company A borrows at 6 percent in euro but company B borrows at 8 percent in dollars.
C)Yes,A will be better off by €1 percent on €1m; B by 1 percent on $2m and $2.00 = €1.00.
D)No,company A saves 1 percent in euro but company B saves only 1 percent in dollars when the spot exchange rate is $2.00 = €1.00-A is twice as better off as B.

Question

Consider the dollar- and euro-based borrowing opportunities of companies A and B. $\begin{array}{ccc} 
& € \text { borrowing } & \$ \text { borrowing } \
\mathrm{A} & € 7 \% & \$ 8 \% \
\mathrm{~B} & € 6 \% & \$ 9 \%
\end{array}$ A is a U.S.-based MNC with AAA credit; B is an Italian firm with AAA credit.Firm A wants to borrow €1,000,000 for one year and B wants to borrow $2,000,000 for one year.The spot exchange rate is $2.00 = €1.00 and the one-year forward rate is given by IRP as $\frac { \$ 2.00 \times ( 1.08 ) } { € 1.00 \times ( 1.06 ) }$ = $\frac { \$ 2.0377 } { € 1.00 }$ .
Suppose they agree to the swap shown here.Is this mutually beneficial swap equally fair to both parties? 
A)Yes,QSD = [€7% ? €6% × $2.00/€1.00] ? ($8% ? $9%)= $2% + $1% = $3%. 
B)No,company A borrows at 6 percent in euro but company B borrows at 8 percent in dollars. 
C)Yes,A will be better off by €1 percent on €1m; B by 1 percent on $2m and $2.00 = €1.00. 
D)No,company A saves 1 percent in euro but company B saves only 1 percent in dollars when the spot exchange rate is $2.00 = €1.00-A is twice as better off as B.

Quizplus · Accepted Answer

To determine if the swap is mutually beneficial and equally fair to both parties, we need to calculate the QSD (quasi-spot differential) for the swap.

QSD = (€ borrowing rate of A - € borrowing rate of B x forward rate) - ($ borrowing rate of A - $ borrowing rate of B)
QSD = (0.07 - 0.06 x 2.0377) - (0.08 - 0.09)
QSD = 0.01 + 0.01
QSD = 0.02 or 2%

Since QSD is positive, this swap is mutually beneficial. To determine if it is equally fair to both parties, we need to compare the savings each company will realize.

A will save on euro-based borrowing costs, while B will save on dollar-based borrowing costs. Based on the swap, A will pay €1,000,000 x 0.06 = €60,000 in interest, while B will pay $2,000,000 x 0.09 = $180,000 in interest. Using the spot exchange rate of $2.00 = €1.00, A will save €10,000 (€70,000 - €60,000), which is 1% of the amount borrowed. B will save $20,000 ($200,000 - $180,000), which is also 1% of the amount borrowed.

Therefore, the swap is equally fair to both parties as each company saves 1% of the amount borrowed in their respective currencies.

Consider the Dollar- and Euro-Based Borrowing Opportunities of Companies a and B