Question

1. Firm B, with a better credit rating, has lower borrowing costs in both types of borrowing. Firm A and Firm B face the following rate structure: (3pts)

                     Preferred            Fixed             Floating

Firm A           Fixed                   8.0%             6-month LIBOR+0.6%

Firm B           Floating 6.8%             6-month LIBOR

a)  Devise a swap agreement (without a swap bank) such that A and B will share the benefit equally? Compute the after-swap borrowing costs for Firm A and Firm B, and also determine cost savings for both firms.

b) Suppose that a swap dealer offers the following swap quotes:

• Firm A pays BigBank 7.20% for LIBOR.
• Firm B pays BigBank LIBOR for 7.00%.

What is the after-swap cost for each company? What is the profit for the swap dealer and cost savings for Firms A and B?

Answer 1

Firm A required Fixed, cost is 8.0%

Firm B required floating, cost is 6 month Libor

Total Cost = 8.0% + 6 month LIBOR

Under mutual swap,

A will borrow at floating, Cost is     6-month LIBOR+0.6%

B will borrow fixed, cost is 6.8%

So, total cost = 6 - month LIBOR+ 7.4%

Benefit from swap formula= Total Cost without Swap - Total cost with Swap

=8% + 6 month LIBOR- (6 month LIBOR +7.4%)

= 0.6%

Benefit is shared equally , so benefit to A = 0.3%

Benefit to B = 0.3%

So, Cost to A = Cost of Fixed - savings or benefit of swap

= 8% - 0.3%

= 7.7%

Cost to B = Cost of floating - Swap benefits

= 6 month LIBOR - 0.3%

Cost without swap AfterSwap Cost . Profits. Savings

A. 8% . 7.7% . 0.3% . 0.3%

B. 6 month LIBOR . 6 month LIBOR-0.3%. 0.3% . 0.3%