Question

Interest Rate Swaps ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market; it can borrow funds either at 11 percent fixed rate or at LIBOR + 1 percent floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It can borrow funds either at 10 percent fixed rate or at LIBOR + 3 percent floating rate.

a. Is there an opportunity here for ABC and XYZ to benefit by means of an interest rate swap?

b. Suppose you’ve just been hired at a bank that acts as a dealer in the swaps mar-ket, and your boss has shown you the borrowing rate information for your clients, ABC and XYZ. Describe how you could bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2 percent profit.

**can you please show work or data

Answer 1

						LIBOR+1%
		LIBOR+1
Market						10.50%
								LIBOR+2.5%
									10%	10%
									10%
									Market

ABC borrows from market and pays LIBOR+1%

It passes on the same loan to the Bank and gets LIBOR+1%

ABC takes a loan from Bank and pays a Fixed Rate of 10.5%

Thus ABC saves 0.5%(Gets Loan at 10.5% instead of 11%)

XYZ borrows from market and pays 10%

It passes on the same loan to the Bank and gets 10%

XYZ takes a loan from Bank and pays LIBOR+2.5%

Thus XYZ saves 0.5%(Gets a loan at LIBOR+2.5% instead of LIBOR+3%)

Bank makes 0.5% profit on Fixed Rate Loan (10.5-10)

Bank makes 1.5% profit on floating rate loan (LIBOR+2.5%)-(LIBOR+1%)

Net Profit for bank =1.5+0.5=2%