Firm A and Firm B need to raise $100,000,000 of debt to pay for their projected

Question

Firm A and Firm B need to raise $100,000,000 of debt to pay for their projected capital expenditures. Firm A is a blue chip company with a high credit rating in the corporate debt market. It can borrow funds at either 10.75% fixed rate or at LIBOR + ¼ % floating rate. Firm B is a new firm that is not yet well established presently having a relatively low credit rating in the corporate debt market. It can borrow at 11.70% fixed rate and at LIBOR + 3/8 % floating rate. A bank dealer has agreed to organize a fixed for floating interest rate swap between these two firms. The bank has agreed to charge a ¼ % fees to structure this transaction.

a.What is the size of the Quality Spread Differential (QSD) involving Firm A and Firm B? What does it capture? (8 marks)

b. Organize a swap agreement where the total QSD is distributed among all participants.

Explanation / Answer

a)

QSD = Fixed Rate Differential - Floating Rate Differential
QSD = (11.70% - 10.75%) - (LIBOR + 0.375% - LIBOR - 0.25%)
QSD = 0.95% - 0.125%
QSD = 0.825%

b)

There is benefit of 0.825% which can be distributed between the two firms and a third party (a broker or a bank) if the parties enter an interest rate swap.

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