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We are told that Mazabia’s inflation rate could vary between 5% and 15% over the next few
years therefore a swap would appear to be advantageous (as it would fix the future exchange
rates). Without the swap there will be uncertainty over the NPV of the project.question 1. sir why this swap would be beneficial is not clear to me?
question 2: if Mezabian currency depreciates what impacts will this have on casasophia?
If the do not swap then the income from Mazabia will be converted into Euros at whatever the spot rate happens to be in each of the future years.
If the rate of inflation changes in Mazabia (and it might be anywhere between 5% and 15%) the the future spot exchange rates will change (as per purchasing power parity) and therefore the Euro receipts will be uncertain – they may end up with more or they may end up with less.
If they swap then the exchange rates to be used are fixed and there is then no uncertainty as to the future Euro receipts. This is the benefit from swapping.
If the Mazabian currency depreciates against the Euro (and if they have not swapped) then when the receipts are converted into Euros Casasophia will receive fewer Euros.
If the Mazabian currency depreciates against the Euro (and if they have not swapped) then when the receipts are converted into Euros Casasophia will receive fewer Euros.
sir can u pls clarify this a bit more?
If the Mazabia current depreciates then it means that it buys fewer Euros (because Mazurian is worth less). Therefore the receipts in Euros will be less than they otherwise would have been.
sir i had another query regarding this question that is they used (interest rate parity) to convert the 3 years cashflows while they used (purchasing power parity) in order to convert the initial investment, why this is the case? what is the logic behind this
As I do explain in my free lectures, forward rates are calculated using interest rate parity (in exams and in real life), whereas for forecasting future spot rates in the exam we use purchasing power parity in order to estimate.
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