Question

Consider the borrowing costs faced by the following three companies:

Fixed Floating

A 5.0% LIBOR+0.6%

B 6.0% LIBOR+1.3%

C 7.0% LIBOR+2.5%

Assume if entering the swap transaction, they split the possible savings equally.

A) Company A and B want to engage in the swap transaction. What is the possible combined savings for both companies?

B) Suppose company C wants to borrow fixed rate funds. Is it possible for C to reduce its cost of borrowing below 7%, and if so what is the lowest possible cost of could achieve?

C) Suppose company C wants to borrow floating rate funds. Is it possible for C to reduce its cost of borrowing below LIBOR + 2.5%, and if so what is the lowest possible cost it could achieve?

Answer 1

A) Fixed rate difference b/w A and B = 6% -5% =1%

FLoating rate difference b/w A and B = Libor+1.3% -(Libor+0.6%) =0.7%

Since A has more benefit in over B in fixed so A will borrow in fixed and B will borrow in floating.

Combined saving = Fixed differnce - floating difference = 1%- 0.7% =0.3%

B) Yes it is possible to reduce the borrowing cost below 7% if it Get into swap with A or B

For lowest possible cost swap with B
Step 1 : B will borrow at Libor+ 1.3% and C will borrow at 7%

Step2: C will give lend B to 6% so it has loss of 7%-6% % =1 %

Step 3: B will lend to C at Libor+ 1.3% so C benefit= Libor+ 2.5% -Libor+ 1.3% =1.2%

SO overall C has borrowed at 7% --0.2%(=1%-1.2%) benefit =6.8%

C) Similarly by swap with B it can reduce the borrowing by maximum of 0.2% so it can borrow by 0.2% so LIbor+2.3%

Note: Incase of any doubt, please do comment. I will get back to you. Thanks!!