Question

Company Ohio, a low rated firm, desires a fixed rate GBP loan. Ohio presently has access to floating interest rate USD at a margin of 1.25% over LIBOR. Its direct borrowing cost is 11% in the fixed rate GBP market. In contrast, Company Asco, which prefers a floating rate USD loan, has access to fixed rate funds in the GBP market at 9% and floating rate funds at LIBOR + 1/4%.

(a) Identify the comparative advantage of companies Ohio and Asco engaging in a interest rate and currency swap

(b) identify the maximum possible cost saving ___% for Ohio or/and ___% for Asco.

(c) if the cost savings is split equally, the effective interest rate under the swap for Ohio is _____%

(d) if the cost savings is split equally, the effective interest rate under the swap for Asco is _____ over the LIBOR.

(e) If Asco pays Ohio a floating rate dollar at LIBOR + 0.25%, then Ohio must pay Asco a fixed-rate GBP at ______that will enable the two companies to split the cost savings equally.

(f) The possible swap rates of GBP and USD that will enable the two companies to split the cost savings equally are ____% in GBP and ____% in USD.

Answer 1

(a) Identify the comparative advantage of companies Ohio and Asco engaging in a interest rate and currency swap

Difference in the floating rate of the two parties = (LIBOR + 1.25%) - (LIBOR + 1/4%) = 1%

Difference in the fixed rate = 11% - 9% = 2%

Hence, the comparative advantage = Difference of the two differences above = 2% - 1% = 1%

The figures in bold are your answers. The other figures are calculatios and workings for you to understand how they have been derived.

(b) identify the maximum possible cost saving = 1% / 2 = 0.50% for Ohio or/and 1% / 2 = 0.50% for Asco.

(c) if the cost savings is split equally, the effective interest rate under the swap for Ohio is 11% - 0.5% = 10.50%

(d) if the cost savings is split equally, the effective interest rate under the swap for Asco is 1/4% - 0.5% = -0.25% over the LIBOR.

(e) If Asco pays Ohio a floating rate dollar at LIBOR + 0.25%, then Ohio must pay Asco a fixed-rate GBP at 10.50% - [(LIBOR + 1.25%) - (LIBOR + 0.25%)] = 9.50% that will enable the two companies to split the cost savings equally.

(f) The possible swap rates of GBP and USD that will enable the two companies to split the cost savings equally are 10.50% in GBP and LIBOR - 0.25% in USD.