Question

Citibank is arranging a classic interest swap between two companies: Alpha inc. & Beta corp. Alpha can borrow floating rate at LIBOR+0.6% or fixed rate at 7.6%. Beta can borrow floating at LIBOR+1.1% or fixed rate at 9.1%. Alpha wants to pay a fixed rate. If citibank takes 12 bps, how much saving is available to be divided between the two companies?

Answer 1

Floating rate of alpha = LIBOR + 0.6%
Floating rate of beta = LIBOR + 1.1%
alpha expects interest rates to decline andwant floating rate borrowing while beta wants fixed rate borrowing since it expects intereest rate to rise.

	APLHA	BETA
FLOATING RATE	LIBOR+ 0.6%	LIBOR+ 1.1%
FIXED RATE	7.6%	9.1%
	ABSOLUTE ADVANTAGE	COMPARITIVE ADVTG
FIXED RATE	1.5%
FLOATING RATE	0.5%	1% (1.5%- 0.5%)

in this process both the companiees intend to lower their borrowing costs so the bank decides to create a swap agreement. Also, the investors of beta expects it to pay 1.5% more risk premium @ fixed rate than alpha and only 0.5% floating rate.

The comparitive advantage creates andarbitrage opportuniy at 1% if they enter into swap agreement.Then both the companies can split this advantage between them assuming here in equal proportion after deducting citibank's share of 12 basis points.

100 bps- 12 bps = 88 bps can be divided amongst alpha and beta and each one gets advantage of 44 basis points or 0.44% additional savings in interest rates costs.