Example: Dow Chemical $($US$)$ wants to hedge Euro exposure by borrowing in Euros. Michelin $($French$)$ wants dollars to finance US investments. Both want $$250$ mil equivalent at a fix rate for $10$ years.

Company

Borrowing rates

Borrowing cheaper

$($home currency$)$

In need of

USD

EUR

Dow Chemical $($US$)$

$6\mathrm{.}00\%$

$7\mathrm{.}00\%$

USD

EUR

Michelin $($France$)$

$7\mathrm{.}50\%$

$6\mathrm{.}50\%$

EUR

USD

Current spot rate EUR$/$USD $=1\mathrm{.}2500.$ Therefore they should do currency swap $($fixed$-$for$-$fixed$).$

Dow Chemical $($US$)$

Michelin $($France$)$

Borrowing $$250$ mil by issuing $6\mathrm{.}00\%$ bonds

Swapping $$250$ mil for $200$ mil

Paying interest $$250$m $*6\%=$ $$15$ mil $/$ year

Swapping back $200$ mil for $$250$ mil

Paying back $$250$ mil debt

Borrowing $200$ mil from the bank at $6\mathrm{.}50\%$

Swapping $200$ mil for $$250$ mil

Paying interest $200$m $*6\mathrm{.}5\%=13$ mil $/$ year

Swapping back $$250$ mil for $200$ mil

Paying back $200$ mil debt

Saving $1\%$ interest $=$ $$250$m $*1\%=$ $$2\mathrm{.}5$ mil $/$ year

Saving $1\%$ interest $=200*1\%=2$ mil $/$ year

Interest rate swap $($fixed$-$for$-$floating$)$ is similar in borrowing with cheaper cost. Principals may not be swapped because unlike currency swap $($in need of foreign currencies$),$ this is to get lower interest rates.

Company

Borrowing rates

Borrowing cheaper

$($home currency$)$

Swapping for

$($both save $0\mathrm{.}5\%)$

USD

EUR

Dow Chemical $($US$)$

$6\mathrm{.}00\%$

LIBOR $+3\%$

Fixed $(6\mathrm{.}00\%)$

Float $($LIBOR $+2\mathrm{.}5\%)$

Michelin $($France$)$

$7\mathrm{.}50\%$

LIBOR $+2\%$

Float $($LIBOR $+2\%)$

Fixed $(7\%)$

The problem. Current exchange rate is $/$$ $=1\mathrm{.}6000.$

Dell Inc. $($US$)$ wants to borrow $10$ mil for $2$ years and rates are $9\%$ for pound vs$.7\%$ for dollar.

Virgin Airlines $($UK$)$ wants to borrow $$16$ mil for $2$ years and rates are $8\%$ for dollar vs$.8\mathrm{.}5\%$ for pound.

What swap transaction would accomplish the objectives? $(10$ points$)$

How much did each party save per year if they swap the original rate? $(5$ points$)$

What is the cost savings for each party per year if Dell paying $8\mathrm{.}75\%$ to Virgin for pounds, and Virgin pays $7\mathrm{.}75\%$ for dollars? $(5$ points$)$