Question

Steelers & Penguins Sports Clubs both seek the lowest financing cost. They face the following rates:

                                                                             Steelers                                    Penguins                

Credit Rating                                                          A                                            BBB

Cost of fixed funds                                             4.0%                                         5.5%

Cost of floating funds                            6 MO Libor + 1.00%               6 MO Libor + 1.75%

If a swap is set up such that any potential savings are divided equally between the two clubs, what will be the net post swap cost for Penguins?

Answer 1

Steelers has a comparative advantage in both Fixed Funds and Floating funds as compared to Penguins. However the comparative advantage of borrowing in fixed costs in more than borrowing floating cost.

To maximize the profit, Steelers will borrow at fixed rate and Penguins will borrow at variable rate. Thereafter they will enter into a Swap where Steelers will lend at a fixed rate to Penguins and Penguins will lend at a variable rate to Steelers.

Interest rate without the swap will be as follows :
Steelers : 6 Month Libor + 1%
Penguins : 5.5%

Total = Libor + 6.5%

Interest rate with the swap
Steelers : 4%
Penguins : 6 Month Libor + 1.75%

Total = Libor + 5.75%

Total profit due to Swap = Total Interest Rate without Swap – Total Interest Rate with Swap
= (Libor + 6.5%) - (Libor + 5.75%)
= 0.75%

Therefore,

Profit to Steelers = 0.75%/2 = 0.375%
Profit to Penguins = 0.75%/2 = 0.375%

Net effective rate to Penguins will be = 5.5 – 0.375
                                                            = 5.125%