Question

Counterparties X and Y require $50,000,000 for 5 years.

Based on their credit ratings Counterparties X (BBB rating) and Y (AAA) rating have the borrowing options in the table below. The rates are annual interest rates.

"Original" Terms:

Counterparty	Fixed Rate	Floating Rate
X	5%	6-month LIBOR + .25%
Y	4.4%	6-month LIBOR

Suppose the Swap Bank offers the following quote against dollar LIBOR: 4.50-4.65%.

Party X: Gets floating rate loan from its bank but WANTS to swap into fixed payments by paying the swap bank 4.65% against receiving LIBOR.

Party Y: Gets fixed rate loan from its creditors but WANTS swap into floating payments lower than LIBOR, by paying the swap bank LIBOR against receiving 4.5%

Complete the following sentences.

Recommended: Show or explain your work for each question. Feel free to use a diagram to work out your answer on paper. (Enter in whole number form. Do not include the % symbol and do not represent as a decimal. For example, if the net interest is 82.35%, enter 82.35. Do not enter 82.35%. Do not enter .8235)

1. Company X’s net interest after the swap will be (A)  %. Therefore, compared to their independent options, they will save a total over 5 years of (B)  dollars.

2. Company Y’s net interest after the swap will be (A)  %. Therefore, compared to their independent options, they will save a total over 5 years of (B)  dollars.

3. What percent does the swap dealer make?  %

Answer 1

Y can borrow cheaper in both fixed and floating rate as compared to X (Y has absolute advantage in borrowing in both fixed rate and floating rate)

Y can borrow 0.6% cheaper in Fixed rate but only 0.25% cheaper in floating rate as compared to X

So, Y has comparative advantage in fixed rate borrowing and X has comparative advantage in floating rate borrowing

Since X has floating rate loan but wants to swap into fixed payments by paying the swap bank 4.65% against receiving LIBOR.

So,Company X’s net interest after the swap will be = 6 month LIBOR+0.25%- LIBOR+4.65% = 4.90%

Compared to independent option, they will save a total of $50,000,000* (5%-4.9%)*5 =$250,000 over 5 years

Since Y has fixed rate loan but wants to swap into floating payments by paying the swap bank LIBOR against receiving 4.5%.

So,Company X’s net interest after the swap will be = 4.4%- 4.5%+LIBOR = LIBOR -0.1%

Compared to independent option, they will save a total of $50,000,000* (LIBOR-(LIBOR-0.1%))*5 =$250,000 over 5 years

The Swap dealer pays LIBOR rate to X and receives the same from Y

It also receives 4.65% from X and pays 4.5% fixed rate to Y

So, the Swap dealer makes a % gain of 0.15%