Question

Steelers & Penguins Sports Clubs both seek the lowest financing cost. They face the following rates:

                                                                              Steelers                                      Penguins                

Credit Rating                                                           A                                              BBB

Cost of fixed funds                                              4.0%                                           5.5%

Cost of floating funds                             6 MO Libor + 1.00%                6 MO Libor + 1.75%

If a swap is set up such that any potential savings are divided equally between the two clubs, what will be the net post swap cost for Penguins?

	a.	Libor + 1.375
	b.	5.125%
	c.	4.75%
	d.	Libor + 1.25

Answer 1

Here difference between fixed rate = 4 - 5.5 = -1.5%

and difference between floating rate = LIBOR + 1 - LIBOR - 1.75 = -0.75%

So, Steelers has advantage in borrowing at fixed rate and Penguins has advantage in borrowing at floating rate.

So, benefit available or Maximum gap = 1.5 -  0.75 = 0.75%

So, Penguins eventual rate will be fixed rate and it will decrease by 0.75/2 = 0.375%

So, net post swap cost for Penguins = 5.5 - 0.375 = 5.125%

Option b is correct.