Banana Co, a multinational corporation headquartered in the U.S., wishes to borrow 10 million for three years to finance the expansion of its British subsidiary. Orange Ltd, a company based in the UK, wishes to borrow $13 million for three years to finance an investment in the U.S. The three-year fixed borrowing interest rates for each company are as follows:

Dollar fixed rate Sterling fixed rate

Banana Co 4.5% 7.5%

Orange Ltd 4.1% 5.5%

The current spot exchange rate between the U.S. dollar and sterling is 1.3 dollars per pound. Banana Co and Orange Ltd both seek to lower borrowing cost as much as possible and hedge exchange rate risk. A swap dealer has agreed to arrange a currency swap for the two companies.

(i)Design a currency swap that would benefit all three parties - Banana Co, Orange Ltd and the swap dealer.

(ii)Calculate all principal and interest payments, in both dollars and pounds, for the life of the swap agreement.

(b)Explain how the value of a currency option contract is affected by the following factors:

(i)the current spot exchange rate;

(ii)volatility of the underlying exchange rate.