Problem:
Company US wants to borrow €6,500,000 at a fixed rate for 3 years; Company EUR wants to borrow $8,500,000 at a fixed rate for 3 years. The current spot exchange rate is US$1.23/EUR. Their external borrowing opportunities are shown below:
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$ Borrowing Cost
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€ Borrowing Cost
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Company US
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$3%
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€4%
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Company EUR
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$5%
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€4.5%
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A swap bank arranges a swap. Company US issues $8,500,000 of three-year debt at a fixed rate of 3%; Company EUR issues €6,500,000 of three-year debt at a fixed rate of 4.5%. The swap bank proposes the following currency swap:
Company EUR will pay the swap bank annual payments on $8,500,000 with the coupon rate of 4.8%; in exchange the swap bank will pay to Company EUR interest payments on €6,500,000 at a fixed rate of 4.5%. Company US will pay the swap bank interest payments on €6,500,000 at a fixed rate of 2.8% and the swap bank will pay Company US annual payments on $8,500,000 with the coupon rate of 3%.
Requirement:
Question 1: What is the annual value of this swap to the swap bank assuming all exchange rate risk is hedged?
Question 2: If no exchange rate risk is hedged, what is the exchange rate risk (USD appreciation or depreciation against the EUR) the swap bank is exposed to? At what USD per EUR exchange rate does the swap bank break even?
Note: Please explain comprehensively and give step by step solution.