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 a...

Bank A needs to borrow $10 million to finance a floating rate Eurodollar loan to its client. To avoid the interest rate risk, floating rate note (FRN) is preferable. Company B needs to borrow $10 million to finance an investment project. To avoid the interest rate risk, a fixed rate loan is preferable. Bank A can borrow at a fixed rate of 10.0% and a floating rate of LIBOR flat. Company B can borrow at a fixed rate of 12.5% and a floating rate of LIBOR + 1.0%. A swap bank is used as an intermediary 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 (QSD).

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

Borrowing Matrix

In an interest rate swap, the difference between the interest rates of debt obligations offered by two parties of different creditworthiness that engage in the swap. A swap transaction is considered beneficial to both parties only when the QSD is positive.

QSD in above example = (12.50% - 10.00%) - (LIBOR+1.0%-LIBOR)

=1.50%

(b) Gain to be received by each party = 1.5% / 3 = 0.50%

Bank A borrowed at fixed rate of 10% p.a.

Then entered into a swap where it will pay LIBOR and receive fixed.

Therefore Bank A should Received 10%+0.50% = 10.50% {fixed rate Bank is paying on borrowings + 0.50% of shared benefit}

(c) Gain to be received by each party = 1.5% / 3 = 0.50%

Company B borrowed at LIBOR +1%.

Then entered into a swap where it will pay fixed of 10.50%.

Therefore Company B should Received LIBOR - 0.5%

Bank A Company B Diff in Borrowing Cost Fixed Borrowing Cost 10% 12.50% 2.5% Floating Borrowing Cost LIBOR LIBOR+1.0% 1.0% Quality Spread Differential (QSD) 1.5%

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