Reading 40: Risk Management Applications of Swap Strategie

The European firm can borrow euros at 7 percent and lend them at that rate to the U.S. firm who then saves 1 percent. The American firm, in turn, can borrow dollars at 7 percent and lend them at that rate to the European firm who then also saves 1 percent. It could also be possible for the American firm to re-lend the dollars at, say 7.5 percent, and still get the Euros at a lower rate, say 7.1 percent. Such an arrangement would mean the net rate on the loan is less than 7 percent for the American firm and more than 7 percent for the European firm. Such a discrepancy is unlikely, however, and the 1 percent (maximum) savings each is the only possible answer.

Swaps can lower overall borrowing costs by allowing firms to borrow at a lower rate within their own country rather than paying a higher rate by borrowing directly in the foreign currency. For example, a U.S. borrower needing euros would have to pay a higher rate than a counterparty in Europe. The European counterparty can borrow at a lower rate and pass the savings on to the U.S. borrower who passes similar savings back via borrowing dollars in the U.S. and exchanging them for the euros. None of the other answers make sense.

The borrower has borrowed dollars and pays a floating rate. Becoming the floating-rate receiver in the swap will mean swapping the dollars and getting the floating-rate payments on the dollars to pass through to the original lender. The borrower will then pay fixed on the euros received.