Question

Tebow Trust can fund 12.75 percent fixed-rate assets with either variable-rate liabilities at LIBOR + 1 percent or fixed at 12.5 percent. Swamp Bank can fund variable-rate assets with either fixed-rate liabilities at 11 percent or variable at LIBOR + 0.5 percent. Swamp’s variable-rate assets earn LIBOR + 1.25 percent. Tebow and Swamp could agree on an interest-rate swap with the fixed-rate swap payment at 11.25 percent and the variable-rate swap payment at LIBOR .

What will be the net after-swap cost of funds for the Tebow Trust if the cash market liabilities are included in the analysis?

Answer 1

Tebow trust has fixed rate assets. It would be better if it has fixed rate liabilities with rate less than 12.75%. However, it has cheaper loans at floating rate of LIBOR+1%

Similarly, Swamp bank has floating rate assets, hence it would be better if it has floating rate liabilities at a rate of less than LIBOR+1.25%. However it has cheaper fixed rate loans available at 11%

Hence, Tebow trust can take floating rate loan at LIBOR+1% and Swamp bank can take fixed rate loan at 11% and then swap the loans. (note that even though swamp can floating loan at LIBOR+0.5%, it is better if Tebow takes floating rate as otherwise tebow has to take fixed rate at 12.5% which gives a differential of 1.5% over Swamp's fixed rate of 11%. Hence the above arrangement is cheaper due to comparative advantage of the two parties in the two types of loans)

As per swap, Tebow trust would pay 11.25% to Swamp bank towards Swamp bank's loan. Swamp bank would pay LIBOR+0%.

Net after swap cost of funds for Tebow = RECEIVE 12.75% from assets - PAY (LIBOR+1%) for loans - PAY 11.25% as per swap to swamp + RECEIVE LIBOR from Swamp

Net after swap cost for Tebow = 12.75% - (LIBOR+1%) - 11.25% + LIBOR = + 0.5%

Net after swap cost for Swamp = RECEIVE (LIBOR+1.25%) from assets - PAY 11% on loan - PAY LIBOR to tebow + RECIEVE 11.25% from tebow

Net after swap cost for Swamp = LIBOR + 1.25% - 11% - LIBOR +11.25% = + 1.5%

Answer: Net after swap gives +0.5%. Since it assets gives 12.75%, it means liabilities cost 12.75% - 0.5% = 12.25%

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