Problem 2 Consider two companies: Volkswagen and Ford. Volkswagen wants to borro
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Problem 2 Consider two companies: Volkswagen and Ford. Volkswagen wants to borrow USS for the following 3 years at a fixed rate, while Ford wants to borrow Euros also for the following 3 years at a fixed rate. The rates available to two companies in USS and Euro markets are shown below. Ford Volkswagen USS 70% 6,0% Euros 8.0% 5.0% (a) What is the total gain from the currency swap Note that the difference between interest rates in USS market is 7.0-6.0-10%, in Euro market it is 80-5.0-3.0% The difference between the two is 3.0%-1.0%-20% or 200 basis points re fore the total gain from the currency swap is 200 basis points (b) Which firm has the comparative advantage in Euro market, Ford or Volkswagen? Volkswagen. Note that in Euro market the Volkswagen's advantage is 3.0%, while in USS market Volkswagen's advantage is only 1.0% In part c design a currency swap with a Financial Institution as an intermediary. The financial institution will earn 50 basis points, the remaining total gain will be split equally between Volkswagen and Ford (e) Complete chart below. Near each arrow indicate the interest rate and the currency in which it will be paid/received. Financial Institution 4 Ford Volkswagen -Explanation / Answer
b) The term “Comparative advantage” is used here to showcase the advantage that Volkswagen has in Euro market compared to US market, since Volkswagen has been offered a much lower borrowing rate. There can’t be any absolute advantage in such a scenario.
c) In a currency swap, an entity would borrow in the market wherein it has comparative advantage. As in the given scenario, Volkswagen is saving 3% in Euro market and 1% in US market; it would definitely borrow in Euro market to exploit highest possible savings. Since it is a currency swap between Ford and Volkswagen, Ford would also borrow but it would borrow in US market paying an interest rate of 7%. In such a swap, the total profit in terms of interest rate would be 2% as Volkswagen would be paying 1% higher interest in US markets (The same is calculated in part A).
Now, since it is a currency swap with an intermediary in place which would take commission of 50 basis points (0.5%), the net savings will be:
200 basis points – 50 basis points = 150 basis points (1.5%).
Since it is pre-agreed term that the profit will be shared equally between the two companies, each of the company will gain a profit of 75 basis points (0.75%).
The easiest way to calculate the net advantage in such a scenario would be:
Interest saving in one market + Interest saving in the other market – Commission paid
=> 3% + (-1%) – 0.5%
= 1.5%
Gain for a company = Net gain*(Company’s share in net gain)
=> 1.5%*50% = 0.75%
Hope the given explanation helps you understand the concept. In case of any confusion, please comment and I'll help you with further explaination. Please do give "thumbs-up".
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