2.Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assu
ID: 2803331 • Letter: 2
Question
2.Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assume that a swap bank is involved as an intermediary and the bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat. Alpha and Beta Companies can borrow for a five-year term at the following rates: Alpha Beta Moody’s credit rating Aa Baa Fixed-rate borrowing cost 10.5% 12.0% Floating-rate borrowing cost LIBOR LIBOR + 1% (a)Calculate the quality spread differential (QSD). (10 pts) (b)Graph the swap including the external financing costs. (20 pts) (c) What is the all-in interest rate cost for each of the firms? (20 pts; 10 pts for each firm) (d) How much does the swap bank make (in terms of interest rates)? (10 pts) (e) How much does each firm save per year? (10 pts) (f) Assume Alpha and Beta want to borrow $ 100,000,000 for 5 years. Further, the LIBOR rate over the next 5 years is expected to be 7%. Report the net borrowing costs (in dollar terms, not interest rates) for both parties. (10 pts)
Explanation / Answer
Multiple questions asked, i solved few of them.
a)Calculate the quality spread differential (QSD).
QSD = (LIBOR + 12%) - (10.5% +(LIBOR+1%))
= 0.5%
there is a gain of 5% in interest savings that can be enjoyed by both parties.
(c) What is the all-in interest rate cost for each of the firms?
The both firms construct an interest rate swap
Here, Alpha needs to pay LIBOR to beta and beta needs to pay 10.5% to Alpha.
That means: Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR + 1%.
Since, in this problem we have equal split of the QSD, the final result of the swap will be as, Alpha gets a floating rate of LIBOR – 0.25%; and Beta gets 11.75% (12%-0.25%).
Therefore, Both will achieve a 0.25% interest rate reduction.
(d) How much does the swap bank make (in terms of interest rates)?
Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at LIBOR+ 1%.
Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8%to the swap bank and receive from it LIBOR.
If this is done, then Alpha’s floating-rate all-in-cost will be = 10.5% + LIBOR - 10.7% = LIBOR - 0.20%.
fixed-rate all-in-cost = LIBOR+ 1% + 10.8% - LIBOR = 11.8%
(e) How much does each firm save per year?
IF NO SWAP IS INVOLVED: Then:
25% savings over issuing floating-rate debt on its own and 0.25% savings over issuing fixed-rate debt.
If swap is involved:
Then, 20% savings over issuing floating-rate debt on its own and 20%savings over issuing fixed-rate debt.
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