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“The swap may not be a worthwhile means of hedging currency risk if the exchange rate is unpredictable. If it is assumed that exchange rates are largely determined by inflation rates, the predicted inflation rate in Wirtonia is not stable, making it more difficult to predict future exchange rates confidently. If the movement in the exchange rate is not as expected, it may turn out to have been better for Buryecs Co not to have hedged.”
sir in a currency swap, the two companies are not exposed to exchange rate fluctuations on interest payments, because here for example, the eurozone subsidiary in wirotnia will pay the loan taken by out by the counterparty (in wirtonian $s) and the counterparty’s subsidiary will pay the eurozone parent the loan payments there in europe itself. so exchange rate exposure in the intervening years( assuming the both subsidiaries in the respective countries have enough cash to meet interest payments) is nil.
so if there exists no swap for the intermediate years how this line becomes a disadvantage of swaps ?
The statement is not saying that it is a disadvantage.
The workings in the answer to (b)(ii) calculate there to be a gain, but with different inflation rates and therefore exchange rates this is not guaranteed.
sir that’s where the problem is. Am saying that there will be no exposure to exchange rate in the intermediate years as interest rate payments will not be from foreign nation to another nation, but from co’s operations in a foreign country to the company with whom the swap has been entered into. essentially the interest payments are being done intra country is what my point is
or is it that am understanding currency swap incorrectly. and that the interest payments in hte intervening years will be from one country to another? thus exposed to foreign exchange
As the examiner has written in his answer, the interest payments in $’s can be matched against the recipes in $’s so reducing the foreign exchange risk.
However here is still risk attaching to the exchange of the principal at the beginning and end, because that is at today’s spot rate (and of course there is risk attaching to the income itself).
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