Question.

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% and pounds sterling at 12%. Jones can borrow dollars at 9% and pounds sterling at 10%. 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?

Answer.

Dow should borrow $4 million in dollars externally at $10%; pay 11% in pounds to the swap bank on a notational principal of 2 million; receive $10% from the swap bank on a notational principal of $4million. Jones, borrows 2 million pounds externally at 10%; pays $8% to the swap bank on a notational principal of $4 million and receives 10% in pounds from the swap bank on a notational principal of 2 million.

Please explain why do this swap.