Question

(a) Prawn and Lobster are two companies that can borrow for a five year term at the following rates.

	Prawn	Lobster
International credit rating	A	B
Fixed-rate borrowing cost	6.5%	10.5%
Floating-rate borrowing cost	LIBOR + 1%	LIBOR + 3%

(i) Calculate the quality spread differential (QSD).

Enter your answer as a percentage to 2 decimal places, e.g. 1.23 (1 Mark)

Answer %

(ii) Develop an interest-rate swap in which both Prawn and Lobster have an equal cost savings in their borrowing costs. Assume that Prawn desires floating-rate debt and Lobster desires fixed-rate debt. No swap bank is involved in the transaction. Assume that the payments are all made against flat Libor. Assume that Libor is currently 4%.

Fill in the blanks. Enter answers as one of the following formats. Numbers should be percentages to 2 decimal places, e.g. 1.23, LIBOR, LIBOR + 1.23

Prawn would borrow at a rate of Answer % from their bank.

Lobster would borrow at a rate of Answer % from their bank.

Prawn will pay AnswerLIBOR6.5% to Lobster.

Lobster will pay Answer6.5%LIBOR to Prawn.

Prawn's all in cost is Answer %

Lobster's all in cost is Answer %

(iii) Based on the information above suppose a swap bank is offering the following quote on USD Libor 7.1 – 7.2

Under this scenario Prawn will pay AnswerLIBOR7.1%7.2% to the swap bank and Lobster will pay AnswerLIBOR7.1%7.2%.

Based on this calculate the gain (in basis points) for:

Swap Bank - Answer bps (1 mark)

Prawn - Answer bps (1 mark)

Lobster - Answer bps (1 mark)

(b) The current spot exchange rate is EUR1.45 / USD 1.00, and the one year forward exchange rate is EUR1.4163 / USD 1.00. The one-year interest rate is 5% in euros and 4.5% in US dollars. You can borrow USD 4,000,000, or the equivalent EUR amount today, at the current spot exchange rate.

(i) Show how you can make a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Round all figures to the nearest number.

Fill in the blanks.

Borrow Answer in currency AnswerUSDEUR and convert to currency AnswerUSDEUR for a total value of Answer in currency AnswerUSDEUR

(ii) Calculate the size of the arbitrage profit. (1 Mark)

The arbitrage profit should be Answer in currency AnswerUSDEUR

Answer 1

a)

i) Quality Spread Differential = Fixed rate debt differential - Floating rate debt differential

=(10.5%-6.5%) - (LIBOR + 3%- (LIBOR+1%))

= 4%-2%

= 2%

ii) In the Interest rate swap, Prawn borrows in the external market at 6.5% in the fixed rate and Lobster borrows at LIBOR +3% in the floating rate. Then they undergo an interest rate swap as per following terms

i) Prawn to pay LIBOR to Lobster and receive 6.5% in fixed rate

So,

Prawn would borrow at a rate of 6.50% from their bank.

Lobster would borrow at a rate of LIBOR+3%or 7.00% from their bank.

Prawn will pay Answer LIBOR or 4.00% to Lobster.

Lobster will pay Answer 6.50% to Prawn.

Prawn's all in cost is LIBOR or 4.00%

Lobster's all in cost is 9.50%

iii) In case of Swap bank

Under this scenario Prawn will pay LIBOR to the swap bank and Lobster will pay 7.2%.

Gain for

Swap Bank - 10 bps

Prawn - 160 bps

Lobster - 30 bps