Two firms, each domiciled in its respective country and having foreign operations in the other's, are seeking to use a swap agreement to reduce their borrowing costs while hedging their currency exposure

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Two firms, each domiciled in its respective country and having foreign operations in the other's, are seeking to use a swap agreement to reduce their borrowing costs while hedging their currency exposure. The Boeing Corporation, based in the U.S., is looking to hedge some of its pound exposure by borrowing in pounds. At the same time, Rolls-Royce based in the U.K., is seeking to finance its investment expansion in the U.S. and wants to borrow in dollars to hedge its dollar exposure. Both want the equivalent of $500 million in fixed rate financing for 5 years. 

 

Boeing can issue dollar-denominated debt in the U.S debt market at a coupon rate of 4.5% and pound-denominated debt in the U.K. debt market at a coupon rate of 5.8%. Rolls-Royce can issue dollar-denominated debt in the U.S. debt market at a coupon rate of 5.2% and pound-denominated debt in the U.K. debt market at a coupon rate of 5%. 

 

Assuming a current spot rate of $1.5/£ and ignoring any transaction cost or fee, structure a currency swap that would enable both firms to reduce their borrowing costs (versus what they would otherwise be) while they have their currency exposures hedged. Show the initial principals exchanged at year 0, the annual payments exchanged, and the final principals exchanged at year 5. Also, compute the overall cost savings available from using a currency swap.