Question

Many loans to corporations are quoted today at small risk premiums and profit margins over the London Interbank Offered rate (LIBOR). Englewood Bank has a $25 million loan request for working capital to fund accounts receivable and inventory from one of its largest customers, APEX Exports. The bank offers its customer a floating-rate loan for 90 days with an interest rate equal to LIBOR on 30-day Euro deposits (currently trading at a rate of 4 percent) plus a one-quarter percentage point markup over LIBOR.

(1) What loan rate would the bank offer?

(2) If APEX wants the loan at a rate of 1.014 times LIBOR and the bank agrees to this loan request, what interest rate will attach to the loan if it is made today?

3) What does this customer’s request reveal about the borrowing firm’s interest rate forecast for the next 90 days?

Hint: Use the price leadership model. Show your works.

Answer 1

(1) What loan rate would the bank offer?

The loan rate offered by the bank = LIBOR on 30-day Euro deposits (currently trading at a rate of 4 percent) plus a one-quarter percentage point markup over LIBOR = 4% + 0.25% = 4.25%

(2) If APEX wants the loan at a rate of 1.014 times LIBOR and the bank agrees to this loan request, what interest rate will attach to the loan if it is made today?

Interest rate = 1.014 x 4% = 4.056%

3) What does this customer’s request reveal about the borrowing firm’s interest rate forecast for the next 90 days? Hint: Use the price leadership model. Show your works.

If LIBOR changes by say 1%, loan rate as per APEX formula will change by = 1.014 x 1% = 1.014%

Loan rate as per Bank''s formula will change by = 4.25% - 3.25% = 1%

Hence, loan rate change is higher in case of APEX's formula. So, the customer will opt for its own formula if it expects or forecasts that interest rate will decline soon, thereby leading to a higher reduction in interest rate applicable to the loan.