Two U. S. firms - a AAA bank and a BBB rated non-financial corporation - want to

Question

Two U. S. firms - a AAA bank and a BBB rated non-financial corporation - want to raise $100 million each for a 10 year maturity. For various reasons the bank wants to raise floating-rate funds, while the corporation wants to raise fixed-rate funds. The interest rates available to the two firms are as follows: The bank opted to issue the fixed-rate debt, while the corporation issued the Boating rate debt. Simultaneously, they entered into a swap contract with a FI. The terms of the swap are as follows: The bank will pay the FI a rate of 6-month LIBOR, while it will receive a fixed rate of 3.85%. The non-financial corporation will pay the FI a fixed rate of 3.93%, while it will receive 6-month LIBOR. Compute the quality spreads and the net quality spread in this case. Calculate the new net cost to the bank and the corporation by tabulating inflows and outflows. Also show' the cash flows to the FI. Compute the increase or decrease in costs to the two firms and the gain to the FI

Explanation / Answer

a) Quality Spread of Fixed Rate = 4.750-3.625

Quality Spread of Fixed Rate = 1.125%

Quality Spread of Floating Rate = Libor + 0.25% - (Libor + 0.60%)

Quality Spread of Floating Rate = -0.35%

Net Quality Spread = 1.125% -0.35%

Net Quality Spread = 0.775%

b) Cost to Bank = 3.625% + 6 Month Libor - 3.85%

Cost to Bank = 6 Month Libor - 0.225%

Cost to Corporation = 6 Month Libor + 0.60% + 3.93% - 6 Month Libor

Cost to Corporation = 4.53%

Cash Flow to FI =((6 Month Libor - 0.225% + 4.53%) - ( 3.625% +6 Month Libor + 0.60%))*100 Million

Cash Flow to FI = 0.08%*100 Million

Cash Flow to FI = $ 80000 each year

c) Decrease in cost to Bank = (Libor +0.25%) - (Libor-0.225%)

Decrease in cost to Bank = 0.475%

Decrease in cost to Corporation = 4.75%-4.53%

Decrease in cost to Corporation = 0.22%

Gain to FI = Net Quality Spread - Decrease in cost to Bank - Decrease in cost to Corporation

Gain to FI = 0.775% - 0.475% - 0.22%

Gain to FI = 0.08%

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