A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates €10,000,000 a year, received annually. The British company wishes to convert the euro cash flows to pounds once a year. It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds. The current exchange rate is €1.23/£. The fixed rate on a plain vanilla 5-year currency swap in pounds is 1.20% per year, and the fixed rate on a plain vanilla 5-year currency swap in euros is 1.00% per year.
a. Determine the notional principals in euros and pounds for a swap with annual payments that will help achieve the objective.
b. Determine the annual cash flows from this swap, and illustrate the cash flows with a swap diagram.
c. Calculate the effective exchange rate at which the payments are swapped.
1.a)The annual cash flows must be converted into pounds (10000000 Euros)In order to create a swap to convert the 10000000 Euros the notional principals are:Euro notional principal=…