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Answers

Example 4

Smiths Co is a UK based company that has borrowed 10 million British
pounds (GBP) at a fixed interest rate of 5.25% per year, with interest paid
annually.

The company is planning to expand into Europe so wants to swap GBP
10 million for Euros (EUR), and its fixed interest rate for a floating rate.

The bank has quoted a cross currency swap exchange rate of GBP/EUR 1.30
(that is, GBP 1 = EUR 1.30) and interest rates of LIBOR + 0.50% on EUR in
exchange for 5.25% on GBP, with interest paid annually.

Assume that LIBOR is 5% at the start date of the swap.

Required:

Show how the fixed for floating cross currency swap would work in the
circumstances described, assuming the swap is only for one year and
that interest is paid at the end of the year.

Solution

Timing Explanation Cash flows

Now Exchange Pay GBP 10m to
principals (at swap the bank and
rate of GBP1 = receive EUR 13m
EUR 1.30)

End of year Pay swap interest Pay EUR 0.715m
to bank ((LIBOR (on the assumption
+0.50%) × that the start date of
EUR13m) the swap is the
interest rate fixing
date and hence
LIBOR is 5%)

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