HW Assignment # 5

Puneet Agarwal – EPGP – 1914002

1. Suppose Firm A can issue 5-year bonds in the US at the fixed rate of 5% and in India at
9%. Suppose Firm B can issue 5-year bonds at the fixed rate of 7% in the US and at 8% in
India.
a. Show which firm has a comparative advantage in which capital market?

USA India
Firm A (US Firm) 5% 9%
Firm B (Indian Firm) 7% 8%
Difference 2% 1%
So, in USA firm A has comparative advantage while in India Firm B has comparative advantage.
b. How would you advise both firms so that they take advantage of each other's
comparative advantage in the US and Indian capital markets?
To take advantage, Firm A should issue bonds in USA and give raised dollars to Firm B to do
business in USA. Similarly, Firm B should issue bonds in India and give raised INR to Firm A to
do business in India.
c. How much could be saved in borrowing costs by both firms?
Without Swap = 9% + 7% = 16%
With Swap = 5% + 8% = 13%. Thus, Saving = 3%
d. Both firms decide to use Goldman to set up the swap deal for 50 basis points. Set up a
cash flow table and a chart to show the cash flows over the 5-year life of the bonds.

SWAP BANK

7.75% 5.75%
5% 8%

Firm A Firm B
5% 8%
Time Firm A Firm B Bank

0 Borrows USD 1 m Borrows INR 70 m

@ 5%; swap @ 8%; swap

1-5 Coupon (1x.05) = Coupon (70 x .08) Between Bank & Firm A =-50,000 USD + 5.425 Million INR

USD 50,000 = INR 5.6 m Between Bank & Firm B = -5.6 million INR + 57,500 USD

Total = 5,000 USD for one year (which is 50 basis points)

Total for 5 years = 5x5000 = $ 25,000

5 Returns USD 1 m Returns INR 70 m

2. Biogen, a US company, expects to receive royalty payments of GBP 1.5 million next
month. It is interested in protecting the USD value of these receipts. It can use a 30-day
GBP/USD futures contract (contract size GBP 62,500) at a price of 1.6513 or it can use
options (contract size GBP31,250) available at a strike of 1.66--a call option is available for a
premium of 2.0 cents per pound and a put option for 2.5 cents per pound.
The current spot price for GBP/USD is 1.6560 and the pound is expected to trade in the range
of 1.6250 and 1.7500.
1)Develop a plan to hedge Biogen’s FX risk using both futures and options.
Using Short Futures
C $ 0.020 F $ 1.6513
P $ 0.025 X $ 1.6600
C-P $ -0.005 F-X $ -0.0087

(C-P)>F-X so Biogen should create a synthetic short future contract using a short call and buy
a put.
Spot Call Strike Short Future Payoff from Payoff from Total Payoff Payoff using synthetic Payoff from
Price Price Price Short Call Long Put per pound short future Market Short
1.625 1.660 1.6513 0.020 0.010 0.030 $ 45,000 Future
$ 39,450
1.630 1.660 1.6513 0.020 0.005 0.025 $ 37,500 $ 31,950
1.640 1.660 1.6513 0.020 -0.005 0.015 $ 22,500 $ 16,950
1.650 1.660 1.6513 0.020 -0.015 0.005 $ 7,500 $ 1,950
1.660 1.660 1.6513 0.020 -0.025 -0.005 $ -7,500 $ -13,050
1.670 1.660 1.6513 0.010 -0.025 -0.015 $ -22,500 $ -28,050
1.680 1.660 1.6513 0.000 -0.025 -0.025 $ -37,500 $ -43,050
1.690 1.660 1.6513 -0.010 -0.025 -0.035 $ -52,500 $ -58,050
1.700 1.660 1.6513 -0.020 -0.025 -0.045 $ -67,500 $ -73,050
1.710 1.660 1.6513 -0.030 -0.025 -0.055 $ -82,500 $ -88,050
1.720 1.660 1.6513 -0.040 -0.025 -0.065 $ -97,500 $ -1,03,050
1.730 1.660 1.6513 -0.050 -0.025 -0.075 $ -1,12,500 $ -1,18,050
1.740 1.660 1.6513 -0.060 -0.025 -0.085 $ -1,27,500 $ -1,33,050
1.750 1.660 1.6513 -0.070 -0.025 -0.095 $ -1,42,500 $ -1,48,050

Chart Title
$50,000

$-
1.600 1.620 1.640 1.660 1.680 1.700 1.720 1.740 1.760

$-50,000

$-100,000

$-150,000

Payoff using synthetic short future Payoff from Market Short Future

2)Diagram Biogen’s P&L associated with the transaction within the range of expected
exchange rates.
Using Short Futures

Spot Call Strike Short Future Payoff from Payoff from Total Payoff Payoff using synthetic Payoff from Payoff from Total P&L
Price Price Price Short Call Long Put per pound short future Market Short Underlying
1.625 1.660 1.6513 0.020 0.010 0.030 $ 45,000 Future
$ 39,450 $ 24,37,500 $ 24,82,500
1.630 1.660 1.6513 0.020 0.005 0.025 $ 37,500 $ 31,950 $ 24,45,000 $ 24,82,500
1.640 1.660 1.6513 0.020 -0.005 0.015 $ 22,500 $ 16,950 $ 24,60,000 $ 24,82,500
1.650 1.660 1.6513 0.020 -0.015 0.005 $ 7,500 $ 1,950 $ 24,75,000 $ 24,82,500
1.660 1.660 1.6513 0.020 -0.025 -0.005 $ -7,500 $ -13,050 $ 24,90,000 $ 24,82,500
1.670 1.660 1.6513 0.010 -0.025 -0.015 $ -22,500 $ -28,050 $ 25,05,000 $ 24,82,500
1.680 1.660 1.6513 0.000 -0.025 -0.025 $ -37,500 $ -43,050 $ 25,20,000 $ 24,82,500
1.690 1.660 1.6513 -0.010 -0.025 -0.035 $ -52,500 $ -58,050 $ 25,35,000 $ 24,82,500
1.700 1.660 1.6513 -0.020 -0.025 -0.045 $ -67,500 $ -73,050 $ 25,50,000 $ 24,82,500
1.710 1.660 1.6513 -0.030 -0.025 -0.055 $ -82,500 $ -88,050 $ 25,65,000 $ 24,82,500
1.720 1.660 1.6513 -0.040 -0.025 -0.065 $ -97,500 $ -1,03,050 $ 25,80,000 $ 24,82,500
1.730 1.660 1.6513 -0.050 -0.025 -0.075 $ -1,12,500 $ -1,18,050 $ 25,95,000 $ 24,82,500
1.740 1.660 1.6513 -0.060 -0.025 -0.085 $ -1,27,500 $ -1,33,050 $ 26,10,000 $ 24,82,500
1.750 1.660 1.6513 -0.070 -0.025 -0.095 $ -1,42,500 $ -1,48,050 $ 26,25,000 $ 24,82,500

3) Show the effective exchange rate for each option over the expected range of spot
prices.
Using Short Futures
Spot Call Strike Short Future Payoff from Payoff from Total Payoff Payoff using synthetic Payoff from Payoff from Total P&L Effective
Price Price Price Short Call Long Put per pound short future Market Short Underlying Exchange Rate
1.625 1.660 1.6513 0.020 0.010 0.030 $ 45,000 Future
$ 39,450 $ 24,37,500 $ 24,82,500 $ 1.6550
1.630 1.660 1.6513 0.020 0.005 0.025 $ 37,500 $ 31,950 $ 24,45,000 $ 24,82,500 $ 1.6550
1.640 1.660 1.6513 0.020 -0.005 0.015 $ 22,500 $ 16,950 $ 24,60,000 $ 24,82,500 $ 1.6550
1.650 1.660 1.6513 0.020 -0.015 0.005 $ 7,500 $ 1,950 $ 24,75,000 $ 24,82,500 $ 1.6550
1.660 1.660 1.6513 0.020 -0.025 -0.005 $ -7,500 $ -13,050 $ 24,90,000 $ 24,82,500 $ 1.6550
1.670 1.660 1.6513 0.010 -0.025 -0.015 $ -22,500 $ -28,050 $ 25,05,000 $ 24,82,500 $ 1.6550
1.680 1.660 1.6513 0.000 -0.025 -0.025 $ -37,500 $ -43,050 $ 25,20,000 $ 24,82,500 $ 1.6550
1.690 1.660 1.6513 -0.010 -0.025 -0.035 $ -52,500 $ -58,050 $ 25,35,000 $ 24,82,500 $ 1.6550
1.700 1.660 1.6513 -0.020 -0.025 -0.045 $ -67,500 $ -73,050 $ 25,50,000 $ 24,82,500 $ 1.6550
1.710 1.660 1.6513 -0.030 -0.025 -0.055 $ -82,500 $ -88,050 $ 25,65,000 $ 24,82,500 $ 1.6550
1.720 1.660 1.6513 -0.040 -0.025 -0.065 $ -97,500 $ -1,03,050 $ 25,80,000 $ 24,82,500 $ 1.6550
1.730 1.660 1.6513 -0.050 -0.025 -0.075 $ -1,12,500 $ -1,18,050 $ 25,95,000 $ 24,82,500 $ 1.6550
1.740 1.660 1.6513 -0.060 -0.025 -0.085 $ -1,27,500 $ -1,33,050 $ 26,10,000 $ 24,82,500 $ 1.6550
1.750 1.660 1.6513 -0.070 -0.025 -0.095 $ -1,42,500 $ -1,48,050 $ 26,25,000 $ 24,82,500 $ 1.6550