I think we would need to apply a hedge ratio to make it work, so here goes (in simplified terms!):
- For every GBP 100 borrowed, a coupon of GBP 5.75 will be payable
- The gilt (GBP 4.5% / JPY 2%) swap will provide a coupon of GBP 4.5 per GBP 100 nominal
- So we would need to enter into 5.75/4.5 = 1.28 swap contracts to fully hedge the risk
This would be the case if a standard gilts swap is used, i.e. not having an OTC swap. We also need to earn 1.28 * 2% = 2.56% (JPY) from our investment to service the swap agreement.
If an OTC swap was used, we could probably engineer it so that we swap 2.56% JPY for 5.75% GBP, but would involve fees to an investment bank to do so, so perhaps it is cheaper to just use a gilts swap and increase the number of contracts entered into? I don't think we can swap 2% JPY for 5.75% GBP - that's too much risk for any counterparty to take on.
Guess the assumption underlying is that the amount borrowed would not be invested in JPY gilts, but in the business somewhere, and would therefore be expected to return more than just the gilt rate (or else why borrow in the first place).
I hope this helps - I'm a bit rusty on currency swaps!
Last edited by a moderator: Sep 22, 2008