Question

Suppose that today your firm borrows $20 million for 10 years by issuing (selling) one-year bonds that pay today’s one-year Treasury bill rate plus 3%. The firm will then issue new one-year bonds each of the next none years. Today it also loans the $20 million for 10 years at a fixed rate of 8%. What risk does the firm face and how could it hedge this risk with an interest rate swap? Give an example of the terms of a swap that the firm might accept?

Answer 1

Solution :

The firm has borrowed $20 million and paying floating rate ( 1 Yr T bill + 3%)

The firm has loaned $20 million and getting a fixed rate of 8%

Risk:

So firm is facing interest rate risk as if interest rate increases then 1-year T-bill also increase and firm has to pay more as compared to earlier rate. If T-bill rate goes above 5% then the effective payout will be 5+3 = 8% and above.

How to hedge?

Get into swap agreement where

• Change the floating rate into fixed
• Fixed into floating rate

Example: Get into swap agreement where the firm will receive floating rate of T-bill + 3% and pay let's say 7% fixed.

So every year firm will receive T+ 3% and pay 7% from this swap agreement

The loan will pay 8% fixed and firm will have to pay T +3%

So overall firm will receive =  8% - ( T+ 3%) +(T+ 3% ) -7% = 1%

So firm will always have 1% interest irrespective of t-bill rate movement