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**

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