Chapter 9 Mini Case – McDonald’s Corporation’s British Pound Exposure
1. How does the cross currency swap effectively hedge the three primary exposures McDonalds has relative to its British subsidiary. In general, cross currency swap is a contract to swap currencies of debt service obligation (Eiteman, Stonehill, & Moffett, p. 245). For example, McDonalds needs to swap pound denominated fixed interest rate and adopt floating interest rate from the US headquarter. The need to enter into swap agreement depends on the expected floating rate. If the company expects the floating rate to decrease, then it is appropriate to swap fixed for floating. As a result, McDonalds will pay less for the interest payment because of the cross currency
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For instance, the parent company would now be making its interest payments in pounds and in turn will receive dollars. This would be an effective way to hedge the long-term equity exposure with the foreign subsidiary. However, it is important to note the advantages and disadvantages of undertaking a cross-currency swap. For instance, one of the advantages of undertaking a currency swap transaction is that it allows for currency exposure management, in other words it allows for hedging. For instance, when companies decide to undertake a cross-currency swap they are trying to hedge against foreign exchange risk in terms of both principal and coupons as the swap locks in the current market rate (Understanding Cross-Currency Swaps, p. 5). Additionally, there are no upfront costs and the swap arrangements reduce or eliminate convertibility risk and transfer risk. However, there are also some disadvantages associated with cross-currency swaps. For instance, there is some liability risk as well as interest risk. This occurs when swap payments are due when floating rate on the payment leg is higher than that of the receive leg (Understand Cross-Currency Swaps, p. 5). Additionally, currency swaps are highly credit sensitive and can be very difficult to terminate. It is also worth noting that if by any reason one of the counter parties default, then this leaves a currency exposure. 3. Should Anka – and McDonalds – worry about OCI?
Before we can confidently