A company based in the United Kingdom has an Italian subsidiary.The subsidiary generates 25,000,000 a year, received in equivalent semi-annual instalments of 12,500,000.The British company wishes to convert the euro cash flows to pounds twice a year.It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds.The current exchange rate is 1.5/.The fixed rate on a plain vanilla currency swap in pounds is 7.5 percent per year, and the fixed rate on a plain vanilla currency swap in euros is 6.5 percent per year.

a.Determine the notional principals in euros and pounds for a swap with semi-annual payments that will help achieve the objective.

Euro notional principal = 12,500,000/(0.065/2) = 384,615,385

Pound notional principal = 384,615,385/1.5/ = 256,410,257

b.Determine the semi-annual cash flows from this swap.

Company makes swap payment = 384,615,385(0.065/2) = 12,500,000

Company receives swap payment = 256,410,257(0.075/2) = 9,615,385

The company has effectively converted euro cash receipts to pounds.

In this question, I knew the answer. However, I want to know why and explanation for this answer, Thanks.