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Chapter $14$ THE CENTRALIA CORPORATION'S CURRENCY SWAP MINI CASE

The Centralia Corporation is a U$.$S$.$ manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost $5,500,000,$ and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is

$$2,900,000$; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay $7$ percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well$-$known firms of equivalent risk is $6$ percent. Alternatively, Centralia can borrow dollars in the U$.$S$.$ at a rate of $8$ percent.

Study Questions:

Suppose a Spanish MNC has a mirror$-$image situation and needs $$2,900,000$ to finance a capital expenditure of one of its U$.$S$.$ subsidiaries. It finds that it must pay a $9$ percent fixed rate in the United States for dollars, whereas it can borrow euros at $6$ percent. The exchange rate has been forecast to be $$\frac{1\mathrm{.}33}{}1\mathrm{.}00$ in one year. Set up a currency swap that will benefit each counterparty.

$*2.$ Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC$,$ the U$.$S$.$ dollar fixed$-$rate has fallen from $8$ to $6$ percent and the euro zone fixedrate for euros has fallen from $6$ to $5\mathrm{.}50$ percent. In both dollars and euros, determine the market value of the swap if the exchange rate is $$\frac{1\mathrm{.}3343}{}1\mathrm{.}00.$

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