The AIM Holding Company, Inc. is an American based holding company that has subsidiaries selling various types of insurance in the United States and in a number of foreign countries. AIM-Europa is the holding company's European subsidiary. AIM-Europa sells lifetime annuity policies across the Euro Zone (the countries that use the euro as their currency). To be clear, a policy pays a fixed number of euros each month for the life of the policyholder and ceases immediately upon the policyholder's death. The proceeds from the sale of these annuities are transferred to the U.S. where the money is invested in U.S. corporate bonds. In all cases, the monthly payouts to the policyholders were calculated to return 2.75% per annum based on the policyholder's life expectancy. While the actual life-spans of the individual annuity holders are uncertain, AIM-Europa relies on actuarial studies to estimate life expectancies and payouts. At present, if AIM-Europa does not sell any more policies, its current situation is as follows: It is obligated to pay out 20,625,000 monthly for the next 20 years. As already noted, this payout represents a return to the policy holders of 2.75% per annum. The U.S. bond portfolio that supports the annuity policies has been structured to generate $47,431,600 per month, which represents a 4% annual return, for the next 20 years. Both the 2.75% return to the annuity holders and the 4% return to the company assume monthly compounding. Note that the EUR:USD spot exchange rate is currently $1.427.

Questions:

Suppose that there is a currency swap dealer that is prepared to write a fixed-for-fixed currency swap such that the swap dealer is prepared to pay AIM-Europa a fixed rate of 2.75% in euros in monthly installments in exchange for AIM-Europa paying the dealer a fixed rate of 3.25% in dollars, again in monthly installments.

(a) Graphically structure all the cash flows so that you illustrate (1) the relationship between AIM-Europa and its annuity holders; (2) AIM-Euopa and the U.S. bond portfolio; and (3) AIM-Europa and the swap dealer. Determine the notional principal on the dollar leg and the notional principal on the euro leg such that the euro exposure is completely neutralized. Calculate the amount of notional principal in euros, so that the euro risk is gone, and the amount of dollar notionals so that the notionals employed are fair.

(b) Assuming that all other costs incurred by the business (other than the annuity payouts) amount to $3 million per month, is the business profitable?

(c) Which of the risks that you identified in Part A does this structure address (i.e., manage)?

(d) What possible ancillary business advantages do you see from hedging the exchange rate risk?