The following are the available rates at which two companies ABC Limited and XYZ limited can invest in Rupee and US Dollars

 

Fixed Rate (Rs) Fixed Rate (USD)

 

ABC 9% 5%

 

XYZ 6% 4%

 

 

 

ABC wants to invest their money in USD and XYZ wants to invest in Rupee for the next 5 years. Design a Swap with the help of an Intermediary so that the Intermediary gets a net gain of 50 basis points and remaining benefit to be split between ABC and XYZ in the ratio 1:1 respectively. Assume exchange rate risk in two currencies to be taken by intermediary. Determine the cashflows which are exchanged for each of the 5 years. 

ABC is investing in Rupee at 9%, While effective rate to ABC is 5.75% on USD.

So, ABC will pay 9% on Rupee to intermediary and get 5.75% on USD from intermediary.

XYZ is investing in USD at 4%, While effective rate to XYZ is 6.75% on Rupee.

So, XYZ will pay 4% on USD to intermediary and get 6.75% on Rupee from intermediary.

Please find the cashflow based on the assumption of 1$ = Rupee 75 and Both are investing $100 or Rupee 7500.

Change the numbers according to requirement and you'll get the answer.

Let me know if you find any difficulty with new numbers.

ABC wants to invest their money in USD and XYZ wants to invest in Rupee for the next 5 years.

Let's look at comparative benefit for both firm. { Which firm have comparative advantage in which country}

Here we have to do the cross summation of the rates.

1.) Firm ABC invest in USD at 5% and XYZ invest in Rupee at 6% : Effective return = 5% + 6% = 11%

2.) Firm ABC invest in Rupee at 9% and XYZ invest in Dollar at 4% : Effective return = 9% + 4% = 13%

So, In second option both firm is having comparative advantage. Effective advantage = 13% - 11% = 2%.

While both firm want to invest as per first option. So, we do have a swap opportunity here.

Benefit through Swap = 2%

While intermediary will get 50 basis point = 0.5%

So, remaining benefit = 2% - 0.5% = 1.5%, which will be shared equally 1.5%/2 = 0.75% to each firm.

Before swap:

ABC wants to invest their money in USD and they will get 5% and XYZ wants to invest in Rupee and they will get 6%.

Adding benefit of 0.75%

After swap:

ABC will get 5.75% return on USD and XYZ will get 6.75% return on Rupee. While intermediary will get 0.50%

Let's calculate swap arrangement for ABC.

ABC is investing in Rupee at 9%, While effective rate to ABC is 5.75% on USD.

So, ABC will pay 9% on Rupee to intermediary and get 5.75% on USD from intermediary.

Let's calculate swap arrangement for XYZ.

XYZ is investing in USD at 4%, While effective rate to XYZ is 6.75% on Rupee.

So, XYZ will pay 4% on USD to intermediary and get 6.75% on Rupee from intermediary.

Considering current rate of $1 = 75 Rupee

While assume that ABC and XYZ both want to invest $100 or Rupee 7,500

ABC will invest in Rupee 7,500 at 9%, While ABC will get 5.75% on $100.

So, ABC will pay 9% of 7,500 (which they received from investment) = Rupee 675 to intermediary and receive 5.75% of $100 = $5.75 from intermediary.

XYZ will invest in $100 at 4%, While XYZ will get 6.75% on Rupee 7500.

So, XYZ will pay 4% of $100 (which they received from investment) = $4 to intermediary and receive 6.75% of Rupee 7,500 = Rupee 506.25 from intermediary.

So, Effective transaction for intermediary:

Receive Rupee 675 from ABC and Pay Rupee 506.25 to XYZ. Net = 675 - 506.25 = Rupee 168.75

Receive $4 from XYZ and Pay $5.75 to XYZ. Net = 4 - 5.75 = -$1.75

$1.75*75 = Rupee 131.25.

So, 168.75 - 131.25 = 37.5 Rupee (Net gain)