Consider a fixed for fixed currency swap.The Dow Corporation is a U.S.-based multinational.The Jones Corporation is a U.K.-based multinational.Dow wants to finance a £2 million expansion in Great Britain.Jones wants to finance a $4 million expansion in the U.S.The spot exchange rate is £1.00 = $2.00.Dow can borrow dollars at $10 percent and pounds sterling at 12 percent.Jones can borrow dollars at 9 percent and pounds sterling at 10 percent.Assuming that the swap bank is willing to take on exchange rate risk,but the other counterparties are not,which of the following swaps is mutually beneficial to each party and meets their financing needs?
A)Dow should borrow $4 million in dollars externally at $10 percent; pay £11¾ percent in pounds to the swap bank on a notational principal of £2 million; receive $10 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $8¾ percent to the swap bank on a notational principal of $4 million and receives £10 percent in pounds from the swap bank on a notational principal of £2 million.
B)Dow should borrow $4 million in dollars externally at $10 percent; pay £11½ percent in pounds to the swap bank on a notational principal of £2 million; receive $10 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $8½ percent to the swap bank on a notational principal of $4 million and receives £10 percent in pounds from the swap bank on a notational principal of £2 million.
C)Dow should borrow $4 million in dollars externally at $10 percent; pay £11 percent in pounds to the swap bank on a notational principal of £2 million; receive $8 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $10 percent to the swap bank on a notational principal of $4 million and receives £11 percent in pounds from the swap bank on a notational principal of £2 million.
D)There is no swap that is possible.

Question

Quizplus · Accepted Answer

Dow and Jones can both benefit from a swap because they have comparative advantages in different markets. Dow has a comparative advantage in borrowing dollars, and Jones has a comparative advantage in borrowing pounds. By swapping their obligations, they can both potentially reduce their borrowing costs. Option A outlines a swap where both parties can achieve their financing needs at reduced costs compared to their direct borrowing rates in those currencies.

Consider a Fixed for Fixed Currency Swap