Y9 Sri Krishna Industries Limited is an Indian manufacturer of cement-based construction items including sanitaryware. It has a proposal to set up a wholly-owned manufacturing facility in Singapore to cater to the needs of the South East Asian market. A Singapore-based management consultancy firm has prepared the project report, according to which the project is estimated to cost USD 100 million. All the civil works and installation of the machinery can be completed in 12 months. The economic life of the project is estimated at 10 years.
The consultancy firm has suggested that the company opt for foreign debt by issuing Eurobonds of USD 40 million. The remaining cost of the project will be equity financed.
Sri Krishna Industries is a South Indian company and is not well-known even in other parts of India, let alone in foreign markets. Therefore, the company has to offer a premium of at least 2 percent over the coupon rate of 7 percent, which is the borrowing rate for well-known companies of equivalent risk.
At the same time, a Korean MNC has worked out proposals to set up a car manufacturing plant in Southern India. The project cost is estimated at INR 4,500 million with an economic life of 10 years. It finds that it must raise INR 1,800 million by issuing 10 per cent debentures in India, whereas it can borrow U.S.Dollars by issuing Eurobonds at 7 per cent in the European Union market. The spot rate between INR and U.S dollar is INR 44.5. The risk-free interest rate is 8 percent in India and 6 percent in the United States.
2. Suppose that, after one year of entering the swap contract, the risk-free interest rate in the United States has increased by 50bp, while there is no change in the risk-free interest rate in India. Determine the market value of the swap.
Currency swaps are financial agreements between two parties to exchange cash flows in different currencies over a specified period. In this scenario, we will explore how Sri Krishna Industries Limited (SKI) and a Korean Multinational Corporation (Korean MNC) can benefit from a currency swap and how a bank can facilitate this transaction. Furthermore, we will assess the market value of the swap if there’s an interest rate change in the United States after one year.
Sri Krishna Industries Limited (SKI) plans to set up a manufacturing facility in Singapore and needs USD 100 million for the project. The consultancy firm recommends issuing Eurobonds of USD 40 million, with the remaining project cost financed by equity.
The Korean MNC intends to establish a car manufacturing plant in Southern India, requiring INR 1,800 million. They contemplate issuing INR 1,800 million worth of 10% debentures in India, or they can borrow USD at 7% by issuing Eurobonds in the European Union market.
To optimize their financing costs and reduce exchange rate risks, SKI and the Korean MNC can enter into a currency swap agreement. The parties would agree to exchange their respective debt obligations in the two different currencies. Here’s how the swap would work:
SKI issues USD 40 million in Eurobonds and pays interest at 7%.
The Korean MNC issues INR 1,800 million in Indian debentures and pays interest at 10%.
A bank can facilitate this currency swap transaction. The bank would act as an intermediary, connecting SKI and the Korean MNC and providing the required exchange of currencies. Here’s how the currency swap would function:
SKI makes its interest payments to the bank in USD.
The Korean MNC makes its interest payments to the bank in INR.
The bank then converts the INR interest payments into USD using the prevailing spot rate of INR 44.5 per USD.
The bank pays SKI in USD and the Korean MNC in INR, ensuring that each party receives its respective currency without exposure to exchange rate fluctuations.
SKI benefits by obtaining INR funds at a lower interest rate of 7% instead of the 10% debenture rate.
The Korean MNC benefits by accessing USD funds at a 7% interest rate, which may be more favorable than the domestic INR debentures.
Market Value of the Swap After One Year: Suppose the risk-free interest rate in the United States increases by 50 basis points (0.50%) after one year. This change affects the market value of the currency swap.
The market value of the swap is the difference between the agreed-upon exchange rate at the beginning of the swap and the current market exchange rate. If the USD appreciates due to the interest rate increase, the Korean MNC benefits because it can repay its INR-denominated debt with fewer USD.
Currency swaps can provide significant advantages to companies facing cross-border financing challenges. In this case, Sri Krishna Industries Limited and the Korean Multinational Corporation can reduce their financing costs and manage currency risks effectively through a well-structured currency swap facilitated by a bank. Such financial instruments enable companies to optimize their global operations and financing strategies while hedging against exchange rate fluctuations.
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