Question

Q2. Companies XYZ and PQR are facing the following borrowing costs:

	S&P Credit Rating	Fixed	Floating
XYZ	AAA	3.5%	6-month Libor + 1%
PQR	BBB	2%	6-month Libor + 3%

Relative to their credit ratings, do these borrowing costs seem plausible? Which type of loan (fixed vs. floating) should each company pick? Suppose each company above wants to enter into interest rate swaps. How would they do this? Discuss whether the company goes from fixed to floating or vice versa. If possible, also put arbitrary numbers for the interest rates that make sense.

Answer 1

Credit Rating of PQR is BBB which way below the credit rating of ABC which is AAA. Lower the credit rating, higher is the risk and cost of funds is also expected to be higher given the level of risk. But we observe that fixed rate of PQR is below the fixed rate of ABC. Hence such a scenario is difficult to digest.

PQR should pick a fixed rate as the fixed cost of PQR is lower than ABC and likewise, ABC should pick up floating cost.

If for any reason, we assume that PQR wants floating rate and ABC wants fixed rate.

Their total cost in such a case would be = 3.5 + 6M LIBOR + 3 = 6M Libor +6.5

The company can enter into swap interest rate to reduce their total cost.

PQR can borrow at fixed rate and lend money to ABC at fixed rate

ABC can borrow at floating rate and lend money to PQR at floating rate

Now, their effective cost = 6M Libor +1 + 2 = 6M Libor + 3

Hence, their effective cost is reduced by 3.5%. If they agree to share equally, benefit for each company shall be 1.75.

Net cost for ABC = 3.5 - 1.75 = 1.75

Net Cost for PQR = 6 M Libor + 3 - 1.75 = 6M Libor + 1.25