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.

Calculate the amount of the total savings per year

Select one:

a. $25,000

b. $50,000

c. $15,000

d. $5,000

Answer 1

This is a question on comparitive advantage. While the spread of Beta over Alpha for borrowing fixed is 150bps, That for borrowing floating is 100bps. There is therefore a mispricing of 50bps between fixed and floating quotes.

Alpha and Beta can enter into a swap and can reduce their borrowing costs between themselves to the extent of this 50bps.

If they share the saving equally, both can save 25bps

This can happen provided, A;pha borrows fixed (as he has a relative advantage in doing so) and is willing to swap into floating and Beta borrows at floating in market and is willing to swap into fixed.

Between themselves they can save 50bps i.e. 0.5%

On a notional of USD 1Mn, the total savings would therefore amount to USD 5000 per year. Therefore Alpha and Beta can save USD 5000 between themselves.