Consider a Fixed for Fixed Currency Swap

question 45

Multiple Choice

Consider a fixed for fixed currency swap.The Dow Corporation is a U.S.-based multinational.The Jones Corporation is a U.K.-based multinational.Dow wants to finance a £2 million expansion in Great Britain.Jones wants to finance a $4 million expansion in the U.S.The spot exchange rate is £1.00 = $2.00.Dow can borrow dollars at $10 percent and pounds sterling at 12 percent.Jones can borrow dollars at 9 percent and pounds sterling at 10 percent.Assuming that the swap bank is willing to take on exchange rate risk,but the other counterparties are not,which of the following swaps is mutually beneficial to each party and meets their financing needs?

• A)Dow should borrow $4 million in dollars externally at $10 percent; pay £11¾ percent in pounds to the swap bank on a notational principal of £2 million; receive $10 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $8¾ percent to the swap bank on a notational principal of $4 million and receives £10 percent in pounds from the swap bank on a notational principal of £2 million.
• B)Dow should borrow $4 million in dollars externally at $10 percent; pay £11½ percent in pounds to the swap bank on a notational principal of £2 million; receive $10 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $8½ percent to the swap bank on a notational principal of $4 million and receives £10 percent in pounds from the swap bank on a notational principal of £2 million.
• C)Dow should borrow $4 million in dollars externally at $10 percent; pay £11 percent in pounds to the swap bank on a notational principal of £2 million; receive $8 percent from the swap bank on a notational principal of $4 million.Jones,borrows £2 million pounds externally at £10 percent; pays $10 percent to the swap bank on a notational principal of $4 million and receives £11 percent in pounds from the swap bank on a notational principal of £2 million.
• D)There is no swap that is possible.

---

Definitions:

Demand Price

The highest price a consumer is willing to pay for a good or service, reflecting the value placed on it.

Quota Limit

A government-imposed trade restriction limiting the number or value of goods that can be imported or exported during a specified time frame.

Price Ceiling

A price ceiling is a government-imposed limit on how high a price is charged for a product, with the aim of ensuring affordability by limiting how much prices can increase.

Quota Rent

The economic rent received by the holder of a production or import quota, which can be realized by selling the product at a higher price than the world price due to the quota limitation.