The above borrowing rates represent the borrowing rates the firms can obtain for

Question

The above borrowing rates represent the borrowing rates the firms can obtain for a five year fixed rate debt issue in U.S. dollars or Swiss francs. Suppose XYZ wishes to borrow Swiss francs and LMN wishes to borrow U.S. dollars. LMN demands a 10 pct cost of borrowing . First step is for XYZ to borrow $1000 at its 8 percent rate. Using a swap demonstrate, explain how the borrowing costs of each company could be reduced. Assume the spot exchange rate of 2 Swiss francs per dollar.

Explanation / Answer

First step is XYZ will borrow $1000 @ 8% interest

Second step is LMN borrow 2000 swiss francs (1$ = 2 francs) @ 7% interest

Now both will swap the loans as XYZ requires francs and LMN requires Dollars. Amount is the same.

Now to show that they have saved the cost, we calculate one year interest for SWAP and without that.

With SWAP, interest will be $1000*8% + $1000 (Converted from francs)*8% = $ 140

Without SWAP, Interest would have been, for LMN $1000*10% = 100, and for XYZ $1000 (Converted from 2000 francs)*6% = $60, hence total cost for both = $100 + $0 = $160

We can see that with swap, both parties jointly save $20 for an year, they can distribute the gain and both of them will be benefited. Same calculation can be done for 5 years and shown the results.

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