Question

Health Services LTD (HS) and Bonjour inc (BI) both need to borrow $1 million to purchase new computer systems. HS can borrow fixed interest rate funds at 8 percent or variable rate funds at LIBOR plus 0.5% in the debt market. Identify the best swap agreement between HS and BI and label the graph accordingly, given they both are sharing the cost of borrowing equally and there is no inermediary.

BI incurs higher costs of borrowing which are a fixed rate of 11 percent and a variable rate of LIBOR plus 2%

Answer 1

	Health Services LTD (HS)	Bonjour inc (BI)
Fixed Borrowing Cost	8%	11%
Variable Borrowing cost	LIBOR+0.5%	LIBOR+2%

Quality Spread Differential (QSD) or interest rate differential = [11%-8%] - [LIBOR+2%-(LIBOR+0.5%)]= 3%-1.5% = 1.5%

As Fixed rate borrowing is less for HS, hence HS needs to borrow at fixed rate 8% and BI should borrow at LIBOR+2% and they should exchange the interest rates.

HS need to pay to BI , LIBOR+0.5%

and BI should pay to HS, 8%+QSD/2 =8%+1.5%/2 = 8.75%

Now Effective cost for HS = 8%+LIBOR+0.50%-8.75% = LIBOR-0.25% [ Saving of 0.75% as previously HS'S cost was LIBOR+0.5% & Now it is LIBOR-0.25%]

Effective cost for BI = LIBOR+2%+8.75%-(LIBOR+0.5%)=10.25%[Saving of 0.75% as previously BI'S cost was 11%, but now due to swap it is 10.25%]

Total saving = 0.75%+0.75% = 1.50%[which is equal to the QSD]

Hence the

best swap agreement between HS and BI is ,HS needs to borrow at fixed rate 8% and BI should borrow at LIBOR+2% and, then HS need to pay to BI , LIBOR+0.5% and BI should pay to HS 8.75%