Question

Company A and Company B can borrow for a ten-year term at the following rates:

company A prefers floating rate and company B prefers fixed rate.

	Company A	Company B
Moody’s credit rating	AAA	AA
Fixed rate borrowing cost	7%	11%
Floating rate borrowing cost	LIBOR+1%	LIBOR+4%

a. Calculate the quality spread differential (QSD).

b. Assuming that Swap Bank desires to earn _____(please refer to Table 1 as shown below), compute the potential cost saving for each company A and B, if the ratio to divide the balanced cost saving is .

c. What are the effective cost savings for A and B.?

4. Show the transactions designed for A by the Swap Bank for A to achieve its desired effective cost of borrowing.

5. Show the transactions designed for B by the Swap Bank for A to achieve its desired effective cost of borrowing.

(Note that: Please provide detailed transactions for each of the three counter parties with an illustration chart.)

TABLE1

RATIO FOR SHARED BENEFIT BETWEEN A AND B		SWAP BANK'S BENEFIT
A	B
7	7	0.20%

Answer 1

	Company A	Company B
Moody’s credit rating	AAA	AA
Fixed rate borrowing cost	7%	11%
Floating rate borrowing cost	LIBOR+1%	LIBOR+4%

(a) Quality spread differential (QSD) = [11%-7%] - [LIBOR+4%-LIBOR-1%] = 4%-3% = 1%

(b) Assuming that Swap Bank desires to earn 0.20%

Ratio = 7/7 or 1:1

Total saving due to swap = 1% [QSD]

Charge by Swap bank = 0.20%

potential cost saving for each company A and B = [1%-0.20%]*1/2 = 0.40% each.

Assuming that Swap Bank desires to earn ___0.20%__, the potential cost saving for each company A and B is 0.40% each, if the ratio to divide the balanced cost saving is 1:1

(c) What are the effective cost savings for A and B = 0.40%each

(d)

As the fixed rate Borrowing for Company A is less, hence it will borrow at Fixed rate @7%

Company B will borrow at LIBOR+4%.

Company A will pay LIBOR+1% to swap bank and will receive 7.40% from the swap bank.

Company B will receive LIBOR+1% from the swap bank and will pay 7.60% to swap bank.

Effeective cost for Company A = 7%+LIBOR+1%-7.40% = LIBOR+0.60%

Effective cost for Company B = LIBOR+4%+7.60%-LIBOR-1% =10.60%.

		Company A	Company B
	Payment for borrowing	7%	LIBOR+4%
Add	payment to swap bank	LIBOR+1%	7.60%
less	Receipt from swap bank	7.40%	LIBOR+1%
	Total effective cost	LIBOR+0.60%	10.60%
	Cost without swapping	LIBOR+1%	11%
	Cost saving due to swap	0.40%	0.40%

For SWAP Bank
Receipt from Bank A	LIBOR+1%
Receipt from Bank B	7.60%
Total Receipt(X)	LIBOR+8.6%
Payment to Bank A	7.40%
Payment to Bank B	LIBOR+1%
Total payment(Y)	LIBOR+8.40%
Savinf for swap bank(X-Y)	0.20%