Bank A needs to borrow $10 million to finance a floating rate Eurodollar loan to

Question

Bank A needs to borrow $10 million to finance a floating rate Eurodollar loan to its client. To avoid the interest rate risk, FRN is preferable. Company B needs to borrow $10 million to finnace an investment project. To avoid the interest rate risk, a fixed rate loan is preferable. Bank A can borrow a fixed rate of 10.0% and floating rate of LIBOR flat. Company B can borrow at a fixed rate of 12.0% and a floating rate of LIBOR + 0.80%. A swap bank is used as an intermidiary for the deal. The swap bank and the two counterparties of the deal agree that they are going to equally split the total gains from the swap deal.

a)compute the quality spread differential

b)if Bank A agrees to pay LIBOR flat to the swap bank, what interest rate should Bank A receive from the swap bank?

c)if company B agrees to pay 10.50% fixed rate to the swap bank, what interest rate should company B receive from the swap bank?

Explanation / Answer

a)Quaility spread differential = (Interest rate without swap -Effective interest for Company-B after sawp ) + ( Interest rate without swap-Effective interest for Bank-A after sawp )

=(12%-10.2%) + (Libor-Libor)

= 1.8%

..

b)if Bank A agrees to pay LIBOR flat to the swap bank, interest rate that Bank A should receive from the swap bank

= 10%

..

c)if company B agrees to pay 10.50% fixed rate to the swap bank, interest rate that company B should receive from the swap bank = Libor + 0.30%

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