Firms a and B Face the Following Borrowing Rates for a 5-Year

question 73

Essay

Firms A and B face the following borrowing rates for a 5-year fixed-rate debt issue in U.S.dollars or euros:
B. Here is how the swap might work.
Step 1: Firm B borrows $1,000 at a 6% rate in the United States (where it has a comparative advantage) and is obligated to pay $60 per year for 4 years and $1,060 in the fifth year.
Step 2: Firm A calculates that the present value of firm B's debt payments, using its own target 7.5% interest rate, is $939.31. Therefore, firm A borrows this amount of money in Switzerland, where it has its comparative advantage. Firm A borrows 939.31 €. At a 6% interest rate, Firm A must pay:
0.06 x 939.31 = 56.36 euros per year for four years
And then, in the fifth year, Firm A must pay: 56.36 + 939.31 = 995.67 €
Step 3: The two firms enter a swap arrangement to exchange cash flows equal to the other's principal and interest payments. So Firm A pays $60 to Firm B and receives 56.36 € per year for four years. In year 5, Firm A pays $1,060 in return for 995.67 €.
Firm A's net cash flows are as follows: It initially receives $939.31 by exchanging the proceeds from its euro borrowing into dollars. It uses the income from the swap to pay its euro bonds, and pays $60 per year for four years and $1,060 in year 5 on the swap. The effective interest rate (yield to maturity) on this loan is 7.5%, which is better than Firm A could have done in the U.S. (To determine the yield, think of Firm A as effectively issuing a five-year 6% coupon bond for a price of $939.31.)
Firm B receives $1,000 initially, which it exchanges for 1,000 €. Its net cash outflows in the following years are 56.36 €per year for five years and an additional payment of 939.31 €in the fifth year. This corresponds to a yield to maturity of 4.53%, which is a better rate than it could have obtained by borrowing in euros directly. (This is the yield to maturity on a bond sold with a coupon rate of 6%, face value 939.31, at a price of 1,000.)
Both parties receive a better rate than they would have if they had borrowed directly in their preferred currencies.

---

Definitions:

Paper Money

Currency in the form of paper notes issued by a government or central bank and recognized as legal tender for transactions.