Question

Companies A and B face the following interest rates (adjusted for the differential impact of taxes):

	A	B
US dollars (floating rate)	LIBOR + 5%	LIBOR + 1.0%
Canadian dollars (fixed rate)	5.0%	6.5%

Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants to borrow Canadian dollars at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 50-basis-point spread. If the swap is equally attractive to A and B, what rates of interest will A and B end up paying?

Explain in detail.

Answer 1

Solution :-

Company A wants US Floating Rate
Company B wants Canadian Fixed Rate
With out Swap
Company A		US dollar Floating Rate			LIBOR + 5%
Compnay B		Canadian Dollar Fixed rate			6.50%
		Total Interest paid by both			LIBOR + 11.5%
After the Swap Agreement
Both company can take loan for eachother
Company A		Canadian Dollar Fixed rate			5%
Compnay B		US dollar Floating Rate			LIBOR + 1%
		Total Interest paid by both			LIBOR + 6%
Therefore net profit of interest due to wap agreement =
LIBOR + 11.5% - (LIBOR + 6%)			=		5.50%
The Spread paid to financial institution who arranged Swap =					0.50%
Net profit to both the companies of interest =					5%
Share of Company A in interest profit =				2.50%
Share of Company B in interest profit =				2.50%
Rates of interest at which company A and B end up paying
Company A		US dollar Floating Rate			LIBOR + 5% - 2.5%		=	LIBOR + 2.5%
Compnay B		Canadian Dollar Fixed rate			6.5% - 2.5%		=	4%