Calculate expected forward rates
Present Value calculations (Present values in six months)
Net present value = €23·17m – €21·84m = €1·33m
The calculation of the forward rates based on the interest rate parity indicates that the MShs rates are depreciating against the Euro because the Mazabia base rates at 10·8% are higher than the European country’s local base rates at 2·2%.
However, even where the forward rates are fixed, based on interest rate parity, the project is worthwhile for Casasophia Co.
According to the purchasing power parity, future spot currency rates will change in proportion to the inflation level differentials between two countries. Hence if Mazabia’s inflation level is higher than the European Union, its currency will depreciate against the Euro.
Given that the inflation level in Mazabia is expected to range from 5% to 15% over the next few years, there is uncertainty over the NPV of the project in Euros if the swap is not accepted. The swap fixes the future exchange rates, although Casasophia Co will lose out if the inflation rate is lower than 9·7%, since the future spot rate will depreciate by less than what is predicted by the forward rates. The situation will be opposite if the level of inflation is higher than 9·7%.
Casasophia Co will also need to consider the risk of default by the local bank. Casasophia Co may ask Mazabia’s government to act as guarantor to reduce this risk. Overall, if such an agreement could be reached, it would probably be beneficial to agree to the swap to ensure a certain level of income.
Casasophia Co may also want to explore whether it is possible for the grant funding from the European Union being paid to it directly, to reduce its exposure to the likely depreciation of MShs.
