ABC Company and XYZ Company need to raise funds to pay for capital improvements

Question

ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market; it can borrow funds either at 11 percent fixed rate or at LIBOR + 1 percent floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It can borrow funds either at 10 percent fixed rate or LIBOR + 3 percent floating rate.

a. Is there an opportunity here for ABC and XYZ to benefit by means of an investment rate swap?

b. Suppose you've just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients, ABC and XYZ. Describe how you would bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2 percent profit.

Explanation / Answer

a. XYZ has a comparative advantage relative to ABC in borrowing at fixed interest rates, while ABC has a comparative advantage relative to XYZ in borrowing at floating interest rates. Since the spread between ABC and XYZ%u2018s fixed rate costs is only 1%, while their differential is 2% in floating rate markets, there is an opportunity for a 3% total gain by entering into a fixed for floating rate swap agreement.

b. If the swap dealer must capture 2% of the available gain, there is 1% left for ABC and XYZ. Any division of that gain is feasible; in an actual swap deal, the divisions would probably be negotiated by the dealer. One possible combination is 1%u20442% for ABC and 1%u20442% for XYZ:

10.5% 10.0%

ABC<----------------------Dealer <----------------------------------------------- XYZ

------------------------> Dealer --------------------------------------------->

| LIBOR + 1% LIBOR+2.5% |

| |

| |

| LIBOR+1% 10% |

| |

Debt Mkt Debt Mkt

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