Hi, I am struggling with the concept of determining notional principal for converting the cash flows: problem : A U.S. firm wishes to convert its annual cash flows of €1 million each to US$ upon receipt. The exchange rate is currently 0.8€/$, and the swap rates in the U.S. and Europe are 6% and 4%, respectively. Appropriately using a fixed-for-fixed currency swap that does not exchange principal, determine the appropriate notional principal and the annual dollar cash flow to the firm. Could anybody go through the solution and explaining the logic to me? Thanks guys,
If you have 1M Euros you have 1/.8 = 1.25M USD. So the two notionals are 1M Euros and 1.25M USDollars.
sure…the U.S. firm has a €1mln cash flow. this stems from a liability that has a much larger priciple. Step 1) determine the principle. Easy math; in this case it’s €1mln/ 0.04 = €25mln Step 2) determine the equivalent in the other Currency (which gives you principle in the other currency): €25mln/0.8€/$ = $31.25mln Step 3) determine the resulting cash from the new currency’s principle: $31.25mln*0.06 = $1.875mln PER YEAR. General hints: 1) always work with the currency signs. 2) apples to apples - you deal with euro currency, divide by euro rates…never mix and match rates and currencies. 3) i prefer to divide the payments after step three rather than how schweser does it in the middle. that is, if in your example there were semi annual, i would take my step 3 result and divide it by 2. I find for me this keeps it simple. questions?
big willy - your notionals are way off…
AH Striker you are right, I missed that its 1M payments not 1M loan…damn.
Yeah I know. I looked at it realy quick and saw the 1M and thought notional, missed the whole payment thingy…dang it. Haste makes waste.
Thanks guys. It is much clearer now.
Striker, look at the time, BigWilly must be on his way out of his office. 
haha I was :)…I get in at 6:30 and leave around 5 ish.