Currency Swaps

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Question 3a

Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.

Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.

Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:

Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%

Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap.

Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.

Relevant borrowing rates are:

Buryecs Co Counterparty
Eurozone 4·0% 5·8%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 0·6% + 0·4%

In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.

The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.

Exercise price Call options Put options
7·75 2·8% 1·6%
7·25 1·8% 2·7%

Assume a discount rate of 14%.

Required:
(a) Discuss the advantages and drawbacks of using the currency swap to manage financial risks associated with the franchise in Wirtonia. (6 marks)

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Question 3b i

Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.

Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.

Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:

Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%

Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap.

Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.

Relevant borrowing rates are:

Buryecs Co Counterparty
Eurozone 4·0% 5·8%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 0·6% + 0·4%

In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.

The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.

Exercise price Call options Put options
7·75 2·8% 1·6%
7·25 1·8% 2·7%

Assume a discount rate of 14%.

Required:
(b) (i) Calculate the annual percentage interest saving which Buryecs Co could make from using a currency swap, compared with borrowing directly in Wirtonia, demonstrating how the currency swap will work. (4 marks)

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Question 3b ii

Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.

Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.

Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:

Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%

Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap.

Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.

Relevant borrowing rates are:

Buryecs Co Counterparty
Eurozone 4·0% 5·8%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 0·6% + 0·4%

In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.

The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.

Exercise price Call options Put options
7·75 2·8% 1·6%
7·25 1·8% 2·7%

Assume a discount rate of 14%.

Required:
(ii) Evaluate, using net present value, the financial acceptability of Buryecs Co operating the rail franchise under the terms suggested by the government of Wirtonia and calculate the gain or loss in € from using the swap arrangement.

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Question 3c

Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.

Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.

Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:

Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%

Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap.

Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.

Relevant borrowing rates are:

Buryecs Co Counterparty
Eurozone 4·0% 5·8%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 0·6% + 0·4%

In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.

The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.

Exercise price Call options Put options
7·75 2·8% 1·6%
7·25 1·8% 2·7%

Assume a discount rate of 14%.

Required:
(c) Calculate the results of hedging the receipt of $7,500 million using the currency options and discuss whether currency options would be a better method of hedging this receipt than a currency swap. (7 marks)

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Question 4b

Pault Co is currently undertaking a major programme of product development. Pault Co has made a significant
investment in plant and machinery for this programme. Over the next couple of years, Pault Co has also budgeted for significant development and launch costs for a number of new products, although its finance director believes there is some uncertainty with these budgeted figures, as they will depend upon competitor activity amongst other matters.

Pault Co issued floating rate loan notes, with a face value of $400 million, to fund the investment in plant and
machinery. The loan notes are redeemable in ten years’ time. The interest on the loan notes is payable annually and is based on the spot yield curve, plus 50 basis points.

Pault Co’s finance director has recently completed a review of the company’s overall financing strategy. His review has highlighted expectations that interest rates will increase over the next few years, although the predictions of financial experts in the media differ significantly.

The finance director is concerned about the exposure Pault Co has to increases in interest rates through the loan notes. He has therefore discussed with Millbridge Bank the possibility of taking out a four-year interest rate swap. The proposed terms are that Pault Co would pay Millbridge Bank interest based on an equivalent fixed annual rate of 4·847%. In return, Pault Co would receive from Millbridge Bank a variable amount based on the forward rates calculated from the annual spot yield curve rate at the time of payment minus 20 basis points. Payments and receipts would be made annually, with the first one in a year’s time. Millbridge Bank would charge an annual fee of 25 basis points if Pault Co enters the swap.

The current annual spot yield curve rates are as follows:

Year One Two Three Four
Rate 3·70% 4·25% 4·70% 5·10%

A number of concerns were raised at the recent board meeting when the swap arrangement was discussed.

– Pault Co’s chairman wondered what the value of the swap arrangement to Pault Co was, and whether the value would change over time.
– One of Pault Co’s non-executive directors objected to the arrangement, saying that in his opinion the interest rate which Pault Co would pay and the bank charges were too high. Pault Co ought to stick with its floating rate commitment. Investors would be critical if, at the end of four years, Pault Co had paid higher costs under the swap than it would have done had it left the loan unhedged.

Required:
(b) Advise the chairman on the current value of the swap to Pault Co and the factors which would change the value of the swap. (4 marks)

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Question 4c

Pault Co is currently undertaking a major programme of product development. Pault Co has made a significant
investment in plant and machinery for this programme. Over the next couple of years, Pault Co has also budgeted for significant development and launch costs for a number of new products, although its finance director believes there is some uncertainty with these budgeted figures, as they will depend upon competitor activity amongst other matters.

Pault Co issued floating rate loan notes, with a face value of $400 million, to fund the investment in plant and
machinery. The loan notes are redeemable in ten years’ time. The interest on the loan notes is payable annually and is based on the spot yield curve, plus 50 basis points.

Pault Co’s finance director has recently completed a review of the company’s overall financing strategy. His review has highlighted expectations that interest rates will increase over the next few years, although the predictions of financial experts in the media differ significantly.

The finance director is concerned about the exposure Pault Co has to increases in interest rates through the loan notes. He has therefore discussed with Millbridge Bank the possibility of taking out a four-year interest rate swap. The proposed terms are that Pault Co would pay Millbridge Bank interest based on an equivalent fixed annual rate of 4·847%. In return, Pault Co would receive from Millbridge Bank a variable amount based on the forward rates calculated from the annual spot yield curve rate at the time of payment minus 20 basis points. Payments and receipts would be made annually, with the first one in a year’s time. Millbridge Bank would charge an annual fee of 25 basis points if Pault Co enters the swap.

The current annual spot yield curve rates are as follows:

Year One Two Three Four
Rate 3·70% 4·25% 4·70% 5·10%

A number of concerns were raised at the recent board meeting when the swap arrangement was discussed.

– Pault Co’s chairman wondered what the value of the swap arrangement to Pault Co was, and whether the value would change over time.
– One of Pault Co’s non-executive directors objected to the arrangement, saying that in his opinion the interest rate which Pault Co would pay and the bank charges were too high. Pault Co ought to stick with its floating rate commitment. Investors would be critical if, at the end of four years, Pault Co had paid higher costs under the swap than it would have done had it left the loan unhedged.

Required:
(c) Discuss the disadvantages and advantages to Pault Co of not undertaking a swap and being liable to pay interest at floating rates. (9 marks)

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