The Centralia Corporation's 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

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 $$\frac{1\mathrm{.}33}{}1\mathrm{.}00$ in one year. Set up a currency swap that will benefit each

counterparty.

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 $5\mathrm{.}5$ percent. In both dollars and euros, determine the market

value of the swap if the exchange rate is $$\frac{1\mathrm{.}3343}{}1\mathrm{.}00.$