Question

21. Firm AAA can borrow at 6% fixed or in the floating-rate market at LIBOR flat. BBB can borrow at 7.5% fixed or at LIBOR+0.5%. AAA wants to borrow floating and BBB fixed, so that they are interested in entering into an interest-rate swap. What is the swap fixed rate that is equally attractive to both firms? Assume that there is no financial intermediary involved in the swap transaction.

A) 7% B) 6.5% C) 6% D) 5.5%

Answer 1

Comparing the fixed rate of both the Firms = Firm AAA has advantage of 1.5%.

Comparing the Flexible rate of both the Firms = Firm AAA has advantage of 0.5%.

Firm AAA has an absolute advantage of 2% overall.

If the firms divide the benefit equally, i.e. 1% each then the fixed rate swap rate would be 7%.(6%+1%)

Answer = 7%.

Mehcanism of swap = AAA takes a loan @6% and gives to BBB @ 7%. Gain = 1%. Gain to BBB = 0.5%.

BBB takes a loan @LIBOR+0.5% and pass to AAA, AAA loss would be 0.5% because they could have taken the loan themselves @LIBOR. Hence the net gain to AAA would be 0.5%.

Both AAA and BBB gain 0.5% out of swap. Cheers.