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.

If the amount each firm wants to borrow is 100,000,000 payable back in 3 years, can you describe how would you attempt to price the swap for the floating-rate payer firm? What other information you would need for pricing the swap? (Please give answers by expaination, not just a table)

Explanation / Answer

The steps to be considered in Interest Rate Swaps are:

In the present case, ABC company can borrow funds at Libor + 1 percent which is the lowest floating rate among the two firms. ABC company will thus borrow the funds at this rate and forward it to XYZ company. On the other hand, XYZ company can borrow at 10 percent which is the lowest fixed rate among the both firms. XYZ company will thus borrow the funds at this rate and forward it to ABC company.

The savings will be

Total savings will be 3% which can be shared among ABC in their agreed profit sharing ratio or equally, as agreed.

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