Firm ABC is a UK based retailer and Firm XYZ is an Italian manufacturer.

Firm ABC is planning to open a number of retail stores in France and wants to borrow 60 million for 4 years to fund this.

Firm XYZ has an opportunity to acquire a competitor located in the UK and wishes to borrow 50 million for 4 years to fund this acquisition.

The current spot FX rate is S(EUR/GBP)=1.20. The annual borrowing rates available to the firms by issuing four year fixed rate bonds are below:

	Euro Borrowing Rate	Pound Borrowing Rate
ABC	4.3%	5.2%
XYZ	4.0%	5.5%

B2 (b) (7 marks) Suppose that ABC and XYZ both decide to enter into a fixed-for-fixed cross currency swap. Imagine you are a swap bank intermediating between the two firms. You are asked to design a fixed-for-fixed cross currency swap for each firm with the following features:

• Both firms achieve their desired borrowing with no additional FX exposure.
• The annual interest savings by both firms relative to borrowing directly are equal.
• The swap bank profit (on an annual basis) is equal to the interest savings by the firms.

Find the bid and ask rates that the swap bank provides for both and that generate these features and calculate the savings or profits of all parties.

B2 (b) (10 marks) Now suppose that the two firms instead entered into a direct fixed-for-fixed cross-currency interest rate swap with each other. This swap has the following features:

• ABC pays 4.0% on EUR 60 million over 4 years to XYZ
• XYZ pays 5.2% on GBP 50 million over 4 years to ABC
• The firms exchange principals as part of this swap
• The value of the swap is zero at inception.

In one year's time, the market swap rates are 4.1% for the Euro payments, and 5.4% for the Pound payments. The exchange rate in one year's time is S(EUR/GBP)=1.25. Calculate the new value of the swap. Which party would be required to compensate the other in order to terminate the swap?