Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow £5,000,000 fixed for 5 years.The exchange rate is $2 = £1 and is not expected to change over the next 5 years.Their external borrowing opportunities are: $$\begin{array} { c c c }
& \text { \$Bortowing } & \text { £ Borrowing } \
& \text { Cost } & \text { Cost } \
\text { Compary X } & \$ 10 \% & £ 10.5 \% \
\text { Compary Y } & \$ 12 \% & £13 \%
\end{array}$$ A swap bank proposes the following interest-only swap: Company X will pay the swap bank annual payments on $10,000,000 at an interest rate of $9.80 percent; in exchange the swap bank will pay to company X interest payments on £5,000,000 at a fixed rate of 10.5 percent.Y will pay the swap bank interest payments on £5,000,000 at a fixed rate of 12.80 percent and the swap bank will pay Y annual payments on $10,000,000 with the coupon rate of 12 percent. If company X takes on the swap,what external actions should they engage in?
A)They should borrow $10,000,000 at $10 percent.
B)They should borrow £5,000,000 at 10.50 percent interest-only for five years; translate pounds to dollars at the spot rate.
C)They should borrow £5,000,000 at £10.50 percent interest-only for five years; translate pounds to dollars at the spot rate; enter long position in a forward contract to buy £5,000,000 in five years.
D)none of the options

Question

Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow £5,000,000 fixed for 5 years.The exchange rate is $2 = £1 and is not expected to change over the next 5 years.Their external borrowing opportunities are: $$\begin{array} { c c c } 
& \text { \$Bortowing } & \text { £ Borrowing } \
& \text { Cost } & \text { Cost } \
\text { Compary X } & \$ 10 \% & £ 10.5 \% \
\text { Compary Y } & \$ 12 \% & £13 \%
\end{array}$$ A swap bank proposes the following interest-only swap: Company X will pay the swap bank annual payments on $10,000,000 at an interest rate of $9.80 percent; in exchange the swap bank will pay to company X interest payments on £5,000,000 at a fixed rate of 10.5 percent.Y will pay the swap bank interest payments on £5,000,000 at a fixed rate of 12.80 percent and the swap bank will pay Y annual payments on $10,000,000 with the coupon rate of 12 percent.  If company X takes on the swap,what external actions should they engage in?
A)They should borrow $10,000,000 at $10 percent. 
B)They should borrow £5,000,000 at 10.50 percent interest-only for five years; translate pounds to dollars at the spot rate. 
C)They should borrow £5,000,000 at £10.50 percent interest-only for five years; translate pounds to dollars at the spot rate; enter long position in a forward contract to buy £5,000,000 in five years. 
D)none of the options

Quizplus · Accepted Answer

If company X takes on the swap, they will receive a fixed rate on £5,000,000, so they need to borrow £5,000,000 at the same fixed rate to avoid any basis risk. However, the fixed rate for borrowing in pounds is higher (10.5%) than the floating rate for borrowing in dollars (10%). Therefore, they should borrow in pounds and then exchange the pounds to dollars using the spot rate. Additionally, to eliminate the exchange rate risk, they should enter into a long position in a forward contract to buy £5,000,000 in five years. This way, they will have a fixed dollar borrowing cost of 9.80% (the rate they pay to the swap bank) plus the cost of the pounds they borrow (10.50%).

Company X Wants to Borrow $10,000,000 Floating for 5 Years;