In addition to Trident, another important client for you is Hood College. Recent

Question

In addition to Trident, another important client for you is Hood College. Recently, Hood College signed a 5 year agreement with the government of Qatar to accept qualified Qatari students. As part of the deal, CFO of Hood College has agreed to accept tuition payments for these students in euros. Hood’s CFO heard about cross currency swaps and is intrigued. He has asked you for a meeting and he wants you to come prepared with numbers for a cross currency swap with a notional principal of €5 million that will cover Hood’s foreign exchange exposure.
a. To be clear, what type of foreign exchange exposure is Hood facing? Is it appropriate to hedge this using a currency swap? (10 points)
b. Current spot rate is $1.1100/€. Use the numbers in Table A below to construct a 5 year cross currency swap for Hood College. Be sure to explain what Hood will pay and receive and when. (15 points)
c. Hood’s CFO is really intrigued but wants to know if this can be undone, in case this deal with Qatar falls through before the 5 year term is up. He wants you to explain how this cross currency swap can be undone with two years remaining. He asks specifically what the numbers will look like if the swap deal is unwound with two years remaining, assuming that the 2 year fixed rates are 5.35% and 4.40% on euros and dollars, respectively, at the time of unwinding. If the spot exchange rate shall be USD 1.0200/EUR, who pays what to whom CFO wonders.

Explanation / Answer

Answer

Answer (a)

To be clear, what type of foreign exchange exposure is Hood facing? Is it appropriate to hedge this using a currency swap?

Answer :

Hood is going to receive tuition payments for students in euros. Its domestic currency is US Dollar. Hood is facing foreign exchange risk that US dollar will appreciate against Euro in future and it will receive less payment in US Dollar terms over next 5 years.

A cross-currency swap is an agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies . In a cross currency swap, a loan's interest payments and principal in one currency would be exchanged for an equally valued loan and interest payments in a different currency. The reason companies use cross-currency swaps is to take advantage of comparative advantages. For example, if a U.S. company is looking to acquire some yen, and a Japanese company is looking to acquire U.S. dollars, these two companies could perform a swap. The Japanese company likely has better access to Japanese debt markets and could get more favourable terms on a yen loan than if the U.S. Company went in directly to the Japanese debt market itself, and vice versa in the U.S. for the Japanese company.

So If Hood Collage wants to receive US Dollars against Euro, then It can enter into Cross Currency Swap Contract.

Answer (b) & (c)

Note : Can’t Answer (b) & (c) because Table A is missing.

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