Swap question Each scenario below lists a firm’s options for borrowing directly
ID: 2793134 • Letter: S
Question
Swap question
Each scenario below lists a firm’s options for borrowing directly in two different markets. The swap rate between these markets will also be given. The firm will want to borrow in a specific market.
For 1) & 2):
Determine whether it is better to get funding directly from the market you want or indirectly via a swap.
For example, decide whether it is better to borrow directly from the fixed rate market or indirectly by issuing floating rate debt and buying a floating-for-fixed swap.
Assume a principal of $1 million and a duration of 2 years.
demonstrate whether the firm should borrow directly from that market, or indirectly using a swap. For the choice selected, list the firm’s net cash flows as a result of their strategy. Assume a principal of $1 million and a duration of 2 years. If it is a currency swap, assume a principal in pounds of £750,000
(the swap cannot completely balance out the cash flows of a bond as written. You can make the assumption that the firm can cover some fraction of the swap principal from their own funds (rather than being raised by the bond).
1) Goal: Borrow at a fixed rate* Rate Market Fixed* 6% LIBOR + 4%- LIBOR for 3%- Swap 2) Goal: Borrow at a floating rate* Market- Fixed Floating* Swap Rate LIBOR + 4%- LIBOR for 3%Explanation / Answer
1) If we borrow direct, our cost of debt will be 6%. If we borrow floating @LIBOR + 4% and then we do swap for LIBOR for 3% i.e. we will end up paying fixed 7% whcih is more than 6% option available.
So it is better to borrow fixed
2) Here we want to borrow at a floating rate. So option 1 is to borrow at LIBOR + 4% and option 2 will be to borrow at 6% and then swap LIBOR for 3% i.e. we will pay LIBOR and get 3%. So net effect will be we will be paying LIBOR + 6% - 3% = LIBOR + 3%
So it is better to borrow fixed and then swap 3% fixed with LIBOR
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