MINI CASE

The Centralia Corporations Currency Swap

The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost 5,500,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 7 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the United States at a rate of 8 percent.

Study Questions

1.Suppose a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate has been forecast to be $1.33/1.00 in one year. Set up a currency swap that will benefit each counterparty.

2.Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the U.S. dollar fixed rate has fallen from 8 to 6 percent and the euro zone fixed rate for euros has fallen from 6 to 5.5 percent. In both dollars and euros, determine the market value of the swap if the exchange rate is $1.3343/1.00.