Company X wants to borrow $10,000,000 floating for 1 year; company Y wants to borrow £5,000,000 fixed for 1 year.The spot exchange rate is $2 = £1 and IRP calculates the one-year forward rate as $2.00*(1.08)/£1.00*(1.06)= $2.0377/£1.Their external borrowing opportunities are:
A swap bank wants to design a profitable interest-only fixed-for-fixed currency swap.In order for X and Y to be interested,they can face no exchange rate risk
What must the values of A and B in the graph shown above be in order for the swap to be of interest to firms X and Y?
A)A = £7%; B = $9%.
B)A = $8%; B = £6%.
C)A = $7%; B = £7%.
D)A = $8%; B = £8%.

Question

Company X wants to borrow $10,000,000 floating for 1 year; company Y wants to borrow £5,000,000 fixed for 1 year.The spot exchange rate is $2 = £1 and IRP calculates the one-year forward rate as $2.00*(1.08)/£1.00*(1.06)= $2.0377/£1.Their external borrowing opportunities are: 
 A swap bank wants to design a profitable interest-only fixed-for-fixed currency swap.In order for X and Y to be interested,they can face no exchange rate risk 
 What must the values of A and B in the graph shown above be in order for the swap to be of interest to firms X and Y?
A)A = £7%; B = $9%. 
B)A = $8%; B = £6%. 
C)A = $7%; B = £7%. 
D)A = $8%; B = £8%.

Quizplus · Accepted Answer

For company X borrowing floating for 1 year, the external borrowing opportunity is at 8.5%. Therefore, in order for X to consider the swap, the fixed rate offered by the swap bank must be lower than 8.5%.

For company Y borrowing fixed for 1 year, the external borrowing opportunity is at 7%. Therefore, in order for Y to consider the swap, the fixed rate offered by the swap bank must be lower than 7%.

Looking at the graph, we can see that the intersection of the lines at A=7% and B=9% satisfies both conditions, as the fixed rate offered by the swap bank is lower than both external borrowing opportunities. Therefore, the swap would be of interest to firms X and Y if the swap bank offers these rates.

Company X Wants to Borrow $10,000,000 Floating for 1 Year;