Reference no: EM131933928

One of our students, John Walden, asked me a question after we finish the currency swap example on the night of Nov. 13. John was confused why would company A agree to such a swap agreement. If we take a look at the interest rate offered to both companies from the market: Borrow U.S. Dollar Borrow British Pound Company A 8% 11.6% Company B 10% 12% Based on the market offer, company A has the comparative advantage of borrowing U.S. dollar, and company B has the comparative advantage of borrowing British pound (it is intuitive since company A is headquartered in U.S. and company B is headquartered in U.K.). However, company A wants British pound for its U.K. expansion, while company B wants U.S. dollar for its U.S. expansion. The swap agreement: company A borrows U.S. dollar at 8% from the market, and company B borrows British pound at 12% from the market. Then they sit down and do the swap. After the swap, A pays net 11% on the British pound, and B pays net 9.4% on U.S. dollar. The problem is, it looks like company B is completely ripping company A off! John’s question was, why doesn’t company A just borrow U.S. dollar and exchange it to British pound to fund its business? This way, company A only pays 8% interest on U.S. dollar. Why on earth would company A agree to such a swap and eventually pay 11% interest on the British pound, even though 11% interest rate on British pound is 0.6% lower than the U.K. market offers? Why on earth would company A ever want to pay interest based on U.K. market rate which is much higher than the rate in U.S. market? I was tired that night, and I wasn’t thinking. Could you help John out? And to my knowledge, John and his family have been experiencing an extremely difficult time in the past few weeks. While facing medical complications, people (including the most experienced doctors) are powerless from time to time. However, the least we can do is wish John and his family the best and help him clear up his confusion.