Question

A financial institution has brought together two firms who seek access to new debt capital for expansions of their operations.

Company AAA is concerned about rising interest rates and seeks fixed rate financing, while company BBB is prepared to take what it believes to be the attractive current variable rate
which is on offer.

The two firms have existing arrangements in place for sources of financing, however AAA can attract funds from the Eurodollar market at what it believes to be beneficial rates.

AAA: Fixed: 7%

AAA: Floating: LlBOR+3.5%

BBB: Fixed: 9%

BBB: Floating: LIBOR+6.5%

1.Assuming no transaction costs, clearly indicate the size of any observed mispricing of risk.
2.Clearly indicate any absolute advantage in financing. Why is this likely to be the case? (I mark)
3.Clearly indicate any comparative advantages in financing. (I mark)
4.The financial institution helps to create a swap which is beneficial to both parties and requires a net total compensation package of 0.2% of the total funds involved (this does not mean 0.2% from each company, this means 0.2% total compensation). Assume that any available benefits are split evenly between the two companies and design a swap which is acceptable to both companies and to the financial institution. Clearly indicate the swap rates that the two companies and the financial institution arc using. Clearly indicate the final borrowing rate for

each company.

If the question4 cannot be done, Just do the question123

Answer 1

1. The firm BBB has comparative advantage in the fixed rate of 1% as explained in answer 3 below. This 1% advantage will be equally beneficial to both the companies.

2. Firm AAA has absolute advantage in both fixed and floating interest rate market over BBB.

Firm AAA has absolute advantage of 2% in fixed rate (9-7) and of 3% in floating rate ((Libor+6.5)-(Libor +3.5))

3. Firm BBB has comparative advantage in the fixed rate. Looking at the floating rate difference of 3%, the fixed rate of interest for firm BBB should be 10%, but it is 9%, hence BBB has a comparative advantage.

4. BBB will borrow at 9% from bank and lend it to AAA at 7%

AAA will borrow at LIBOR + 3.5% and lend it to BBB at LIBOR + 4%

The effective interest rate for BBB will be (-9+7-LIBOR-4) = -(LIBOR + 6)

Hence, BBB will pay LIBOR + 6 interest rate

The effective interest rate for AAA will be (-LIBOR - 3.5 + LIBOR +4 -7) = -6.5

Hence, AAA wil pay 6.5% interest rate.

The 0.2% will be equally split between the two companies. Thus, the effective interest rate for AAA is 6.6% and for BBB is (LIBOR + 6.1%)

Both the companies are saving 0.4% interest rate each.