Question 1.6 + 1.7

In: Business and Management

Submitted By dustcircle
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Pages 4
Question 1.6
In short, the objective of this question is to propose a fixed-for-floating interest rate swap that will reduce of cost of borrowing for both parties involved. The available fixed- and floating interest rates are summarized in the following table:

| Company A | Company X | Fixed | 10% | 12% | Floating | LIBOR + 0.25% | LIBOR + 0.75% |

As can be seen from the table, Company A has an absolute borrowing advantage in the sense that Company A has access to both lower fixed and floating borrowing rates. Despite this, Company A can still benefit from engaging with Company X in an interest swap. The reason is that Company A has a relatively larger advantage in borrowing at a fixed interest rate compared to borrowing at a floating interest rate. The absolute advantage of Company A, however, does imply that Company X will need to pay a spread in order to secure the transaction. To see why, imagine the following agreement:

* Company A borrows at the fixed rate of 10% * Company X borrows at the floating rate of LIBOR 0.75% * Company A (float payer) and Company X (fixed payer) engage in a fixed-for-floating interest rate swap

With this agreement, Company X will reduce its fixed cost of borrowing from 12% to 10%. On the other side, Company A will increase its floating cost of borrowing from [LIBOR + 0.25%] to [LIBOR + 0.75%]. Obviously, Company A would not be willing to engage in this agreement. However, by paying a spread, Company X can incentivize Company A to participate in the swap while still reducing its own cost of borrowing. The minimum possible spread needed is 0.50%. At this spread company A will borrow at LIBOR + 0.25% while company X will borrow at 10.5%.

The above arrangement will thus leave company X better of by reducing the fixed interest rate payments by 1.5% while leaving Company A indifferent between taking…...

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