Question

1. Mumbai Ltd. is an Indian company; they are in the process of raising a US dollar loan and are negotiating rates with City Bank. The Company has been offered a fixed rate of 7% p.a with a proviso that should they opt for a floating rate, the interest rate is likely to be linked to the benchmark rate of 60 basis points over the 10 years US T Bill Rate, with interest reification on a three-monthly basis. The expectations of Mumbai Ltd. are that the dollar interest rates will fall, and are inclined to have a flexible mechanism built into their interest rates. On enquiry they find that they could go for swap arrangement with Chennai India Ltd. who have been offered a floating rate of 120 basis points over 10 year US T Bill Rate, as against a fixed rate of 8.20%.

Describe the swap on the assumption that the swap differential is shared between Mumbai Ltd. and Chennai India Ltd. in the proportion of 2: 1.

The answer should be a min of 700 words with complete theory and calculation part

Answer 1

If a company plans to fix floating rate debt through an interest swap and its expectations regarding the behavior of interest rates are uncertain, it could acquire a put option on the treasury bond with a similar maturity. So if interest rates rise, the option is exercised to offset the high cost of the Swap generated by the rise in rates. Conversely, if the rates fall, the option will expire worthless, but You will obtain a benefit by having fixed variable rate debt at a lower fixed rate than the prevailing one.

This type of contract is the most common in the financial markets. A normal interest rate swap is a contract by which one party to the transaction agrees to pay the other party an interest rate set in advance on a nominal amount also set in advance, and the second party agrees to pay the first at a variable interest rate on the same nominal.

A swap is not a loan, since it is exclusively an exchange of interest rate flows and nobody lends nominal to anyone, that is, the amounts of the principal are not exchanged.