Question

Two companies, ANX and AZE, consider borrowing funds for two years. They have access to borrowing for two years as specified in the table below.

Company	Fixed Borrowing	Floating Borrowing
ANX	6%	LIBOR + 30 bps
AZE	8%	LIBOR + 80 bps

1. Briefly explain which company has an absolute advantage in both fixed and floating borrowing markets.

2. Compute the borrowing rate differential between ANX and AZE in each of the two markets.

3. Discuss ANX and AZE’s comparative advantages in the two markets. Then explain how an interest rate swap could help the two companies transform their liabilities.

4. What is the total potential savings for ANX and AZE if they enter into an interest rate swap? Suppose they split the total potential savings evenly, what is the net borrowing cost for each of the two companies? Assume no financial intermediary is involved in the interest rate swap.

5. ANX and AZE have been told that an interest rate swap is equivalent to a series of forward rate agreements (FRAs). Explain the difference between an interest rate swap’s settlement payment and an FRA’s.

Answer 1

Solution 1:-

Company ANX has absolute advantage over company AZE in both the markets because it can borrow at the lower interst rate in both the givrn scenerios.

Solution 2:-

Interest rate diffrential is the difference in the rate of interest between two similar options or securities. In the present case we have two options for borrowing that is fixed and floating rate of interest.

Computation of Borrowing rate diffrential
In fixed market - Interset rate diffrential is 2% (8%- 6%)

In the Floating rate market- Interest rate diffrential is 50bps (LIBOR+80bps)-(LIBOR+30bps)

Solution 3:-

ANX company has the comparative advantage over AZE since it can borrow at the lower rate of interest in both of the markets.

Interst rate swap

Lets start with the fixed rate market. ANX can borrow at 6% while AZE can borrow at 8%. Simply said, ANX has a comparative advantage of 2% in the fixed rate market.

In the floating rate market, ANX borrows at LIBOR + 0.30% while AZE borrows at LIBOR + 0.80%. From here, I'm guessing you already know that ANX has the comparative advantage as well of 0.50%.

Now by this 2 factors, we can automatically assume that ANX will borrow in the Fixed rate market due to higher comparative advantage while AZE will borrow from the floating rate market to not lose out so much.

The answer is simply the difference in the credit spread between the two markets, 2% - 0.5% = 1.5%

Note that 1.5% is the TOTAL gains from the swap. If they were to spread the gains equally, it would mean ANX would enjoy 0.75% cost savings in the floating rate market while AZE would also enjoy 0.75% cost savings in the fixed rate market using the swap.

Solution 4:-

The swap can easily be conducted using the following steps:

1) ANX borrows from fixed market at 6%

2) AZE will pay ANX monthly fixed interest payments of 6.25%

Note that the net effect here is that AZE essentially pays fixed payment of 0.75% less than he would have without the swap. A gains a total of 1.25% from this cash flow.

3) AZE borrows from the floating market at LIBOR + 0.80%

4) ANX pays AZE monthly floating interest payments of LIBOR + 0.80%

From this cash flow, B has a net effect of 0 in the floating rate payments. A will then use the 1.25% gains in the previous cash flow to offset the cash flow here, enabling A to pay only LIBOR -0.25% monthly. A essentially pays 1.25% less than he would have without the swap as well.

The swap thus allows both parties to gain from the credit spread of 0.5% equally.

Solution 5:-

Forward rate agreements are the agreement entered by the bank to hedge a open position at a predetermined price, which is set at the time of entering the contract. whereas Swap rate agreements are nothin but just transfer benefits enjoyed by two party's to each other so that the overall transaction cost is minimised.

Interest rate swap are not equivalent to a series of forward rate agreements (FRAs). In Swaps the rates are not determined at the inception as they are in the case of forward contracts. Also the forward rate agreement are regularized by the banks unlikely in the case of the Swaps.