The table shows the annual loan rates U.S. and Canadian multinational companies can each obtain on a
Question:
The table shows the annual loan rates U.S. and Canadian multinational companies can each obtain on a five-year, $100 million loan in U.S. dollars and an equivalent five-year, C$142.857 million loan in Canadian dollars.
a. Suppose the U.S. multinational wants to borrow C$142.857 million for five years to finance its Canadian operations, while the Canadian company wants to borrow $100 million for five years to finance its U.S. operations. Explain how a swap bank could arrange a currency swap that would benefit the U.S.
company by lowering the rate on its Canadian dollar loan by .25% and would benefit the Canadian company by lowering its dollar loan by .4%. Describe the financial market conditions that allow the swap bank to provide such rates.
b. Show the swap arrangements in terms of U.S. dollar and Canadian dollar interest payments and receipts in a diagram.
c. Describe the swap bank’s U.S. and Canadian dollar positions.
d. Explain how the swap bank’s position is equivalent to a series of long currency forward contracts. What is the swap bank’s implied forward exchange rate on the contracts?
e. Assume that forward rates are governed by the interest rate parity theorem, that the swap bank can borrow and lend dollars at 9.5% and Canadian dollars at 7%, and that the yield curves for rates in both currencies are flat.
Explain how the bank could hedge its swap position using currency forward contracts. What would be the swap bank’s profit from its swap and forward positions?
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