Suppose that we have to companies, AAACorp and BBBCorp. AAACorp’s credit rating

Question

Suppose that we have to companies, AAACorp and BBBCorp. AAACorp’s credit rating is much better than BBBCorp, and both companies would like to borrow $10 million for 5 years. They have been offered the following rates for fixed rate and floating rate loans: Company Fixed Floating AAACorp 4.0% 6-month LIBOR - 0.1% BBBCorp 5.2% 6-month LIBOR + 0.6% Assume that AAACorp would like to borrow at the floating rate, whereas BBBCorp would like to borrow at the fixed rate. What would happen if the two companies get into a swap agreement in which AAACorp agrees to pay BBBCorp at the 6-month LIBOR rate, while BBBCorp agrees to pay AAACorp a fixed rate of 4.35% on $10 million principal?

Explanation / Answer

AAA cost of borrowing in fixed is 4% and in floating is L - 0.1% ; where as BBB cost of borrowing is 5.2% in fixed and L + 0.6% in floating. AAA has better costing in both but in fixed it is better by 1.2% and in floating by only 0.7% . This difference leads to possible gains by swapping which will maximum of (1.2% - 0.7%) = 0.5% which can be shared by both of them and they can benefit.

Now when AAA borrows fixed at 4% and it lends to BBB at 4.35%, it is making an incremental 0.35% on its fixed borrowing (benefit). BBB borrows floating at L + 0.6% and onward lends to AAA at L. In this case AAA is paying 0.1% higher than it would if borrowed in floating but on net basis its cost reduces by (0.35%-0.1%) = 0.25%. In case of BBB also, it looses 0.6% on its floating borrowing by lending to AAA at L but it gains (5.2%-4.35%) = 0.85% by borrowing fixed from AAA, hence its net benefit is also 0.25% . The total benefit is as we had postulated (0.25% +0.25%) = 0.50%. In numbers the flow will be :

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.