Question

Interest Rate Swap: Use the following borrowing information to structure an interest rate swap between Counterparties A and B, two large, corporate organizations.  Notional Principal: $50 million  Tenor of Swap: Three years  Settlement: Semi-annually; Rates set in advance  Counterparty A is very creditworthy, with capacities to borrow in the fixed rate market at a rate of 4.5%, and in the floating rate market at LIBOR+90.  Counterparty B is fairly creditworthy, with capacities to borrow in the fixed rate market at a rate of 6.25%, and in the floating rate market at LIBOR+220  The Intermediary who arranges the swap and nets the payments charges a fee of 5 bps annually. Savings generated by the swap can be divided in any manner, but inform me of the allocation.  At swap initiation, 180-day LIBOR is 1.70%. Looking into the future, assume that 180-day LIBOR will be 2.10%. A final look into the future shows that 180- day LIBOR will be 1.85% one year from now.  Savings from the swap can be  Your task is to draw the box and arrow diagram and calculate the all-in borrowing cost for Counterparties A and B. Also, determine the net cash flows for the first, second, and third settlements

Answer 1

Company	Fixed Borrowing Cost	Variable Borrowing Cost
A	4.5%	libor+0.9%
B	6.25%	libor+2.2%

Excess spread of B in fixed market = 6.25%-4.5% = 1.75%

Excess spread of B in floating market = libor+2.2%-(libor+0.9%) = 1.3%

Difference in spread = 1.75%-1.3% = 0.45%

Arranger fee = 5bps = 0.05%

Difference - spread = 0.45%-0.05%=0.4%

Gain to both sides individually = 0.4%/2 = 0.2%

Borrowing cost for counterparty A = libor+0.7%

Borrowing cost for counterpart B = 6.05%

	180days	360days	540days
Reference libor	1.7%	2.10%	1.85%
Payment made by counterparty A	(1.7%+0.7%)*$50m/2 = $0.6m	(2.1%+0.7%)*$50m/2 = $0.7m	(1.85%+0.7%)*$50m/2 = $0.6375m
Payment made by counterparty B	6.05%*$50m/2 = $1.5125m	6.05%*$50m/2 = $1.5125m	6.05%*$50m/2 = $1.5125m