Question

1. Suppose that ABC Corp and XYZ Inc are looking to borrow $350,000 and can issue 2-year debt at the following market rates:

Firm	Market	Rate
ABC	Fixed	4.8%
ABC	Floating	LIBOR + 3.1%
XYZ	Fixed	6.3%
XYZ	Floating	LIBOR + 5.2%

Suppose that Citigroup is offering a 1.3%/1.6% bid-ask spread on two-year swaps. That is, they are offering to be the fixed payer in a 2-year swap at a rate of 1.3% APR and a floating payer in a swap with a rate of 1.6% APR.
Suppose also that ABC Corp wishes to borrow at a fixed rate while XYZ Inc wishes to borrow at a floating rate. Show that:

1. XYZ Inc is better off using a swap with Citigroup than directly borrowing from the market
2. Citigroup can take both of these swaps and end up with positive profits on the deals.

Answer 1

Here, ABC Corp. and XYZ Inc. both are looking to borrow $ 350,000.

ABC Corp. wishes to borrow at Fixed Rate while XYZ Inc. wishes to borrow at Floating Rate.

What is Swap?

Swap refers to an exchange of one financial instrument for another between the parties concerned. Swaps can be used to hedge risks of various kinds which include interest rate risk and currency risk. Interest Rate Swaps allows their holders to swap financial flows associated with the two seperate debt instruments. Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.

(a) Determine XYZ Inc. is better off using a swap with Citigroup than directly borrowing from the market.

Here, XYC Inc. wishes to borrow at Floating Rate.

So, if XYZ Inc. decides to borrow on its own, the cost of the borrowing = LIBOR + 5.2%.

And, if XYZ Inc. decides to use swap with Citigroup, the cost of the borrowing = LIBOR + 3.1% + 1.6% = LIBOR + 4.7%.

So, from the above calculation it is clear that, XYC Inc. is better off using a swap with citigroup than directly borrowing from the market as it will reduce the cost of borrowing by 0.5%.

(b) Determine Citigroup can take both of these swaps and end up with positive profits on the deals.

ABC Corp. wishes to borrow at Fixed Rate while XYZ Inc. wishes to borrow at Floating Rate.

So, if the ABC Corpo. and XYC Inc. both decides to borrow on its own, total cost of the borrowing

= 4.8% + LIBOR + 5.2%

= LIBOR + 10%.

And, if the ABC Corpo. and XYC Inc. both decides to enter into interest rate swap, total cost of the borrowing

= LIBOR + 3.1% + 6.3%

= LIBOR + 9.4%.

So, from the above calculation, it is clear that if both the ABC Corpo. and XYC Inc. both decides to enter into interest rate swap, there will be saving of 0.6% on the total borrowing, which will be shared as profit between Citigroup, ABC Corpo. and XYZ Inc.. So, we can say, Citigroup can take both of these swaps and end up with positive profits on the deals.