Question

Consider the information below which shows the rates at which firm X and firm Y are able to borrow in the fixed- and variable-rate debt markets. Prepare a fully labelled diagram to show the construction and cash flows of the direct interest rate swap. In your diagram, show which firm will initially borrow fixed-rate debt and which firm will borrow variable-rate debt. Assume the comparative advantage net differential is to be shared equally between the companies.

This will be a direct swap without an intermediary.

LIBOR rate 1.90800%

Debt markets Firm X      Firm Y

Fixed-rate funds   12.00% 14.00%

Variable-rate funds LIBOR + 0.50% LIBOR + 1.70%

Answer 1

Ans.

Debt Market	Firm X	Firm Y	Differential
Fixed Rate Fund	12%	14%	2.00%
Variable Rate Fund	LIBOR + 0.50%	LIBOR + 1.7%	1.20%
Net Differential			0.80%

The firms will borrow according to the greatest comparative advantage in the market.

Firm X will borrow in the fixed rate market, while firm Y will borrow in the variable rate market; and then they will enter into a swap. Firm X and Y both will receive 0.40% of the net differential.

The diagram is as follows

Calculation of net cost of Borrowing

Firm X		Firm Y
Pay to market	-12%	Pay to Market	- LIBOR + 1.7%
Receive from Firm Y	13.60%	Receive from Firm X	LIBOR + 1.7%
Net	1.60%	Net	0
Pay to Firm Y	- LIBOR +1.7%	Pay to Firm X	-13.60%
Net Payment	LIBOR + 0.1%	Net Payment	13.60%

For firm X the net cost of Borrowing from Variable rate fund is reduced to LIBOR + 0.1% as compare to LIBOR + 0.5% and the saving is of 0.4%.

For firm Y the net cost of Borrowing from Fixed rate fund is reduced to 13.6% as compare to 14% and the saving is of 0.4%.