Question

Two companies have investments which pay the following rates of interest:

Fixed Float

Firm A 6% Libor

Firm B 8% Libor + 0.5%

Assume A prefers a fixed rate and B prefers a floating rate. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B, what rates could A and B receive on their preferred interest rate?

Could you please show me how actually the swap diagram looks like? Thank you

Answer 1

An interest rate swap is a financial derivative that companies use to exchange interest rate payments with each other.

Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead.

Each group has their own priorities and requirements, so these exchanges can work to the advantage of both parties.An interest rate swap is a contractual agreement between two parties to exchange interest payments.

As per given case,

   Firm A prefers fixed rate i.e. 6% Libor

Firm B prefers Floating rate i.e. 8% Libor+0.5%

And in given case intermediary is charging 0.1% fee.

Now lets assume both company have invested $100,000 in that case

Company A will get 6% of $100,000 - 0.1% of $100,00

= $6000-$100 = $ 5900 in a Year

Company B will get 8.5 % of $100,000 - 0.1 % of $100,000

= $8500-$100

= $8400

So in above case Firm B is making more return than Firm A however in case of SWAP Firm B will gain $2500 from Firm A instead of getting whole amount $ 5900 or $8400.