A firm will be receiving a semiannual cash flow of Euro20 million. The swap rates in the US and Europe are 4.0% and 4.6%, respectively. The current exchange rate is Euro1.2/$. Identify the appropriate swap needed to convert the periodic euro cash flows to dollar.
I have no idea what this question is asking?
Please help.
each period Company is receiving 20 M Euro.
Wants to convert to $ here. and does not want to suffer the Exchange rate issues.
So company pays the Swap counter party the 20 Mill euro each semi annual period and gets a fixed amount of $ (without suffering the exchange rate issues).
So each period pays 20M Euro as 4.6% as some Principal’s interest payment.
20 / (0.046/2) = Notional Principal in Euro. = 869.565 Mill Euro.
Convert this to Notional in -\> @ 1.2 Euro / => 724.638 Mill $.
Now it receives the 4% rate in USD => 724.638 * 0.04 / 2 = 14.493 Mill $.
It’s asking, what cash flow in USD will be fair exchange for the cash flow in Euros?
Your (or at least my) first response would be to convert the Euros to USD using the exchange rate.
WRONG!
There is an implicit appreciation of one currency against the other due to the interest rate parity.
So first calculate what the notional principal would be, in Euros, on which you would get this cash flow as interest, using the European interest rate. Then convert that NP to dollars. Then calculate the USD cash flow using the American interest rate on that NP.
And don’t forget the frequency. 4.6% is actually 2.3% twice a year, so use 2.3% for European rate and 2% for American.
Thanks guys.
Very good explaination. I think I got it.
Just another note,
no floating side to this swap right?