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 Steelers? a. Libor – 0.375 b. Libor + 0.625 c. 4.75% d. 3.625%

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, Steelers eventual rate will be floating rate and it will decrease by 0.75/2 = 0.375%

So, net post swap cost for Steelers = LIBOR + 1% - 0.375% = LIBOR + 0.625%

Option b is correct.