Question

A company based in the United Kingdom has a German subsidiary. Th e subsidiary generates €15,000,000 a year, received in equivalent semiannual installments of €7,500,000. The British company wishes to convert the euro cash flows to pounds twice a year. It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds. Th e current exchange rate is €1.5/£. The fixed rate on a plain vanilla currency swap in pounds is 7.5% per year, and the fixed rate on a plain vanilla currency swap in euros is 6.5% per year.

1. Determine the notional principals in euros and pounds for a swap with semiannual payments that will help achieve the objective.

2. Determine the semiannual cash flows from this swap

Answer 1

Answer 1: First Convert the Semiannual payments in to Pound 15,000,000/2 = 7,500,000 euros

For Euro notional principal divide this by fixed rate on plain vanilla currency swap and as it semiannual that rate will get halved

Euro Notional principal = 7,500,000 / (0.065/2) = 230,769,230.8 euros

This amount of euros needs to be converted in to Pound at the rate 1 pound = 1.5 euro

Pound notional principal = 230,769,230.8/ 1.5 = 153846153.8 pounds

Answer 2: Semi annual Cash Flow from this swap are

As they are Semiannual rate will get halved

Company who is Making Swap Payment = 230,769,230.8 *(0.065/2) = 7,500,000 Euros

Company who is Receiving Swap Payment = 153846153.8 * (0.075/2) = 5769230.76 Pounds