Interest Rate Swaps ABC Company and XYZ Company need to raise funds to pay for c
ID: 2799911 • Letter: I
Question
Interest Rate Swaps 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 at LIBOR +3 percent floating rate. a. Is there an opportunity here for ABC and XYZ to benefit by means of an interest rate swap? b. Suppose you've just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients, ABC and XYZ. Describe how you could bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2 percent profit.Explanation / Answer
The difference between fixed rates of the two firms = Fixed rate of ABC – Fixed rate of XYZ = 11%-10% = 1% = 100 basis points
The difference between floating rates of the two firms = Floating rate of ABC – Floating rate of XYZ = Libor +1% -Libor +3% = -200 basis points
For each of the firms either fixed or floating is more preferred depending on where they have a comparative advantage. Firm XYZ prefers fixed rate while Firm ABC prefers floating rate.
The spread of their comparative advantage is given by difference in fixed and floating spreads of the firms which is = 100 basis points – -200 basis points = 300 basis points
This difference in spreads can be used by both the firms to reduce the cost of investments.
Intermediary fees for both firm = 2% =200 basis points
Total spread available to firms after intermediary’s fees = 300 basis points – 200 basis points = 100 basis points
Both A and B can receive rates of 50 basis points each on their preferred interest rates.
XYZ would get 10.5% Fixed while ABC would get Libor +1.5%.
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