Application of concepts 5.

SWAPS

Q 1. Lluvia Manufacturing and Paraguas Products both seek funding at the lowest possible cost.
Lluvia would prefer the flexibility of floating rate borrowing, while Paraguas wants the security
of fixed rate borrowing. Lluvia is the more credit-worthy company. They face the following rate
structure. Lluvia, with the better credit rating, has lower borrowing costs in both types of
borrowing.
         
Lluvia wants floating rate debt, so it could borrow at LIBOR+1%. However it could borrow
fixed at 8% and swap for floating rate debt. Paraguas wants fixed rate, so it could borrow fixed at
12%. However it could borrow floating at LIBOR+2% and swap for fixed rate debt. What should
they do?

Q 2. Companies X and Y have been offered the following rates per annum on a $5 million 10-
year investment:

Fixed Rate Floating Rate

Company X 8.0% LIBOR
Company Y 8.8% LIBOR

Company X requires a fixed-rate investment; company Y requires a floating-rate investment.

Design a swap that will net a bank, acting as intermediary, 0.2% per annum and will appear

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equally attractive to X and Y.

Q 3. Companies A and B face the following interest rates (adjusted for the differential impact of
taxes):

A B
US Dollars (floating rate) LIBOR+0.5% LIBOR+1.0%
Canadian dollars (fixed 5.0% 6.5%
rate)

Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants to borrow
Canadian dollars at a fixed rate of interest. A financial institution is planning to arrange a swap
and requires a 50-basis-point spread. If the swap is equally attractive to A and B, what rates of
interest will A and B end up paying?

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Q 4. Company A wishes to borrow U.S. dollars at a fixed rate of interest. Company B wishes to
borrow sterling at a fixed rate of interest. They have been quoted the following rates per annum
(adjusted for differential tax effects):

Sterling US Dollars
Company A 11.0% 7.0%
Company B 10.6% 6.2%

Design a swap that will net a bank, acting as intermediary, 10 basis points per annum and that
will produce a gain of 15 basis points per annum for each of the two companies.

Q 5.

Trident Corporation entered into a three-year cross currency interest rate swap to receive U.S. dollars
and pay Swiss francs. Trident, however, decided to unwind the swap after one year – thereby having
two years left on the settlement costs of unwinding the swap after one year. Repeat the calculations
for unwinding, but assume that the following rates now apply:
                 
Assumptions   Values   Swap   3- year   3-year
Rates bid ask
Notional principal   $   Original: US 5.56%   5.59%
10,000,000 dollar
Original spot exchange rate,     Original: 1.93%   2.01%
SFr./$ 1.5000 Swiss franc
New (1-year later) spot exchange            
rate, SFr./$ 1.5560
New fixed US dollar interest   5.20%            
New fixed Swiss franc interest   2.20%            

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Q 6.

Assume Trident enters into a swap agreement to receive euros and pay Japanese yen, on a notional
principal of €5,000,000. The spot exchange rate at the time of the swap is ¥104/€.
                 
a. Calculate all principal and interest payments,  
in both euros and Swiss francs, for the life of the
swap agreement.

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b. Assume that one year into the swap agreement Trident decides it wishes to unwind the swap
agreement and settle it in euros. Assuming that a two-year fixed rate of interest on the Japanese yen
is now 0.80%, and a two-year fixed rate of interest on the euro is now 3.60%, and the spot rate of
exchange is now ¥114/€, what is the net present value of the swap agreement? Who pays whom
what?
                 
                 
Assumptions   Values   Swap   3- year   3-
Rates bid year
ask
Notional principal   €   Euros --   3.24%   3.28
5,000,000 € %
Spot exchange rate, Yen/euro     Japanes   0.56%   0.59
104.00 e yen %
                 

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Q 7. Falcor is the U.S.-based automotive parts supplier which was spun-off from General Motors in 2000.
With annual sales of over $26 billion, the company has expanded its markets far beyond the traditional automobile
manufacturers in the pursuit of a more diversified sales base.
As part of the general diversification effort, the company wishes to diversify the currency of denomination of its debt
portfolio as well. Assume Falcor enters into a $50 million 7-year cross currency interest rate swap to do just that –
pay euro and receive dollars. Using the data in Exhibit 8.13, solve the following:
                 
a. Calculate all principal and interest payments in both currencies for the life of the swap.
                 
b. Assume that three years later Falcor decides to unwind the swap agreement. If 4-year fixed rates of interest in euros
have now risen to 5.35% and 4-year fixed rate dollars have fallen to 4.40%, and the current spot exchange rate of $1.02/€,
what is the net present value of the swap agreement? Who pays who mwhat?
                 
                 
Swap
Assumptions   Values   Rates 7- year bid 7-year ask    
$
Notional principal   50,000,000   US dollar 5.86% 5.89%    

Spot exchange rate, $/€   1.16   Euros 4.01% 4.05%    

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Q 8. A financial institution has entered into a 10-year currency swap with company Y. Under the terms of
the swap, the financial institution receives interest at 3% per annum in Swiss francs and pays interest at
8% per annum in U.S. dollars. Interest payments are exchanged once a year. The principal amounts are 7
million dollars and 10 million francs. Suppose that company Y declares bankruptcy at the end of year 6,
when the exchange rate is $0.80 per franc. What is the cost to the financial institution? Assume that, at
the end of year 6, the interest rate is 3% per annum in Swiss francs and 8% per annum in U.S. dollars for
all maturities. All interest rates are quoted with annual compounding.

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