Question

1. ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market; it can borrow funds either at an 8% fixed rate or LIBOR +1% floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It can borrow funds either at a 9.5% fixed rate or at LIBOR + 0.5% floating rate.

1. Is there an opportunity here for ABC and XYZ to benefit by means of an interest rate swap?
2. Suppose you’ve just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients ABC and XYZ. Use the following flow chart to describe how you could bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 0.5% profit.

Answer 1

a) Firm ABC can borrow funds either at an 8% fixed rate or LIBOR +1% floating rate whereas firm XYZ can borrow funds either at a 9.5% fixed rate or at LIBOR + 0.5% floating rate.

As ABC can borrow funds at a cheaper rate than XYZ in fixed rate but XYZ can borrow funds at a cheaper rate than ABC in floating rate

So, ABC has comparative advantage in fixed rate borrowings and XYZ has comparative advantage in floating rate borrowings

So, if ABC wants to borrow in floating rate and XYZ wants to borrow in fixed rate , then the two firms can benefit by borrowing in their comparative advantage market and i.e. ABC to borrow externally in fixed rate and XYZ to borrow externally in floating rate and thereafter by swapping the interest payments between them, they can benefit by means of an Interest rate swap.

b) The total benefit from the swap = comparative advantage of ABC + comparative advantage of XYZ

= (9.5%-8%) + (LIBOR+1%- (LIBOR+0.5%))

= 1.5%+ 0.5% =2%

The following swap arrangement gives Bank a net profit of 0.5%. and rest of the benefit (1.5%) equally split between ABC and XYZ

ABC 's net payment = 8%-7.75%+LIBOR = LIBOR +0.25% (an advantage of 0.75% over existing rate)

XYZ 's net payment= LIBOR+0.5%-LIBOR+8.25% =8.75% (an advantage of 0.75% over existing rate)

Bank's NET gain = (8.25%-7.75%) + (LIBOR-LIBOR) = 0.50%