Company X Wants to Borrow $10,000,000 for 5 Years; Company

Multiple Choice

Company X wants to borrow $10,000,000 for 5 years; company Y wants to borrow £5,000,000 for 5 years. The exchange rate is $2 = £1 and is not expected to change over the next 5 years. Their external borrowing opportunities are shown below: A swap bank proposes the following interest only swap: X will pay the swap bank annual payments on $10,000,000 with the coupon rate of 9.80%; in exchange the swap bank will pay to company X interest payments on £5,000,000 at a fixed rate of 10.5%. Y will pay the swap bank interest payments on £5,000,000 at a fixed rate of 12.80% and the swap bank will pay Y annual payments on $10,000,000 with the coupon rate of 12%. What is the value of this swap to the swap bank?

A) The swap bank will earn 10 basis points per year; the only risk is default risk.
B) The swap bank will earn 10 basis points per year but has exchange rate risk: dollar-denominated income and pound-denominated costs and default risk.
C) The swap bank will earn 10 basis points per year but has exchange rate risk: pound-denominated income and dollar-denominated costs and default risk.
D) The swap bank will earn 20 basis points per year in dollars but has exchange rate risk: pound-denominated income and dollar-denominated costs and default risk.