QUESTION 27 X Inc has US$ 140 Million LIBOR based loan. It enters into 100 Million LIBOR swap (Spot Exchange rate €1 = US$ 1.40). Swap: US$ LIBOR + 50 basis point = € LIBOR. So, X Inc will pay € LIBOR and receive US$ LIBOR + 50 basis point. Is it a derivative contract?
Given data:
- US$ 140 Million LIBOR based loan
- 100 Million LIBOR swap
- Spot exchange rate: €1 = US$ 1.40
- Swap: US$ LIBOR + 50 basis point = € LIBOR
To determine if the contract is a derivative or not, we need to check if it meets the three criteria of a derivative:
- There must be an underlying (in this case, the US$ 140 Million LIBOR based loan)
- The value of the contract must be derived from the value of the underlying
- The contract must be settled in the future
Since the contract involves exchanging the cash flows based on different LIBOR rates, it meets all three criteria of a derivative contract. Therefore, it is a derivative contract.
To calculate the cash flows, we need to know the current LIBOR rates for US$ and €. Let's assume the current LIBOR rates are:
- US$ LIBOR = 2%
- € LIBOR = 1.5%
The cash flows for X Inc are:
- Pay € LIBOR on 100 Million = 100,000,000 * 1.5% = €1,500,000
- Receive US$ LIBOR + 50 basis points on 100 Million = 100,000,000 * (2% + 0.5%) = US$2,500,000
- Convert US$2,500,000 to € using the spot exchange rate: US$2,500,000 / 1.40 = €1,785,714.29
Therefore, X Inc will pay €1,500,000 and receive €1,785,714.29, resulting in a net inflow of €285,714.29.
