Company A, a British manufacturer, wishes to borrow US dollars at a fixed rate o

Question

Company A, a British manufacturer, wishes to borrow US dollars at a fixed rate of interest. Company B, a US multinational, 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.

Explanation / Answer

The differential between the sterling rates is 0.4% per annum and the differential between the dollar rate is 0.8% per annum, so that the total gain from the to all parties is 0.8% - 0.4% = 0.4% per annum. The bank gets 0.1% per annum from the total gain, and since the swap should be equally attractive to both companies, each of them should get 0.15% per annum from the total gain. This means that Company A will borrow dollars at 7.0% - 0.15% = 6.85% per annum and Company B will borrow sterling at 10.6% - 0.15% = 10.45% per annum. Company A has these three interest rate cash flows: It pays 11% per annum for sterling to its outside lenders. It receives 11% per for sterling from the bank. It pays 6.85% per annum for dollars to the bank. Company B has these three interest rate cash flows: It pays 6.2% per annum for dollar to its outside lenders. It receives 6.2% per annum for dollar from the bank. It pays 10.45% per annum for sterling to the bank.

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