Question

Companies X and Y have been offered the following annual interest rates with semi-annual compounding on $5 million 6-year loans.

Company	Fixed Rate (%)	Floating Rate
X	5.00%	LIBOR
Y	7.00%	LIBOR + 1%

Company X borrows initially at a fixed rate but would like to have a floating rate loan. Company Y borrows initially at a floating rate but would like a fixed-rate loan.

a)    What is the Quality Spread Differential (QSD)?

b)    What is the necessary condition for a fixed-for-floating interest rate swap to be possible?

c)     Assuming X and Y split the gains from the swap equally, what are the net borrowing interest rates that X and Y get?

d)    Design a swap between the two parties that will net each the same amount of interest rate savings for the types of loans they prefer? (Illustrate with the help of a diagram)

e)     If a Financial Intermediary (FI) charges 0.04% a year (split equally between X and Y), how would this affect the final rates that the two parties are paying? (Illustrate with the help of a diagram)

f)      What are the net borrowing interest rates that X and Y get after the expenses of the Financial Intermediary is taken into consideration?

Answer 1

a) (i) QSD on fixed rate is 2% (7% - 5%)

(ii) QSD on floating is 1% (Libor+1% - Libor).

Hence there is a QSD of 1% that benefits both the parties. (2% - 1%)

b) The neccessary condition for a fixed-for-floating swap to be possible is the existence of QSD. There should be a difference between the fixed rates and floating rates for both the parties. In this case there is a difference, hence fixed for floating swap is possible.

c) For X & Y to split the gains equally:

(i) X will have to borrow at:

5% + Libor - 5.5%

= Libor - 0.5%

(ii) Y will have to borrow at:

Libor+0.5% - (Libor - 7%)

= Libor + 0.5% - Libor +7%

= 6.5%

d) Refer below: