Question :

(a) What are the rationales for interest and currency swaps?

(b) Suppose a Swiss firm, SandyCom Ltd, wants to invest in the U.S. The Swiss firm needs US dollars with a term to maturity of 5 years against a fixed interest rate.

However, the Swiss firm is not very well known in the US market, though it is relatively well known in the SFr market. The difference in name recognition is reflected in the interest rate cost of SFr borrowing (9%) and the interest rate costs $ borrowing (11%).

A US firm, Kseven Int., needs SFr financing with a term to maturity of five years against a fixed interest rate. The US firm is not well known in the SFr market, but well known in the $Market. Again the difference in name recognition is reflected in the interest rate cost of SFr borrowing of 9.8% and the interest rate costs of $ borrowing 10.5%.

(i) Show that, without an intermediary, there is a potential gain of 1.3% that exists from a swap transaction.

(ii) You are required to devise a currency swap that would allow each firm to benefit from borrowing cost savings. It was agreed that the Swiss firm would receive 0.5% and the US firm 0.8% of the total 1.3% potential gain. Explain carefully the steps and make clear any assumptions.

(iii) Assuming, as an intermediary, you will charge a fee for arranging the swap. Show the fee charged would affect the potential gain. The fee will be shared by each firm equally. You can assume any appropriate fee.

(iv) Are there any risks involved in such a transaction?