Question

Consider two companies, Alpha and Beta that can borrow at the rate indicated in the table below. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. All interest rates are compounded annually.

	Alpha	Beta
Moody’s credit rating	Aa	Baa
Fixed-rate	5.5%	7.0%
Floating-rate	LIBOR	LIBOR + 1%
Desires to pay at	Floating-rate	Fixed-rate

Estimate the feasibility of a swap arrangement by which the companies can save interest payments and at the same time pay floating- or fixed-interest payments consistent with their preferences. Use $1 million as the notional principal when answering the following parts.

Which of the following statements about the arrangement is incorrect

Select one:

a. In the swap Alpha pays the LIBOR to Beta

b. In the swap Beta pays a fixed rate to Alpha

c. On the market Alpha borrows fixed and pays 5.5%

d. On the market Beta borrows floating and pays LIBOR

Answer 1

This is a question on comparitive advantage. In fixed rate borrowing the spread of Beta over Alpha is 1.5% whereas in floating rate borrowing it is 1%. Banks therefore have mispriced the spreads quoted by 50bps.

Alpha and Beta can therefore save 50bps between themselves if Alpha borrows at a fixed rate of 5.5 and is willing to swap into floating and Beta borrows at floating and is willing to swap for fixed. (which they are as per question).

Statement d. is therefore incorrect. As Beta intitially borrows floating from the market and it can do so at LIBOR + 1%