Question

Atico Company and Xylan Company need to raise funds to pay for capital improvements at their manufacturing plants. Atico 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. Xylan 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.

Required:

Supposed 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 Atico and Xylan. 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.

Answer 1

Answer:

a.

Xylan has a comparative advantage relative to Atico in borrowing at fixed interest rates, while Atico has a comparative advantage relative to Xylan in borrowing at floating interest rates. Since the spread between Atico and Xylan's fixed rate costs is only 1%, while their differential is 2% in floating rate markets, there is an opportunity for a 3% total gain by entering into a fixed for floating rate swap agreement.

b.

If the swap dealer must capture 2% of the available gain, there is 1% left for Atico(ABC)and Xylan(XYZ). Any division of that gain is feasible; in an actual swap deal, the divisions would probably be negotiated by the dealer. One possible combination is ½% for Atico and ½% for Xylan:

refer below for more understanding , and here ABC indicates Atico and XYZ indicates Xylan