Question

Firm C has the ability to issue fixed-rate bonds in the Eurodollar market at a rate of 9%. However, it has a strong preference for paying floating rate interest on their debt, which it could do directly at a rate of LIBOR + 0.25%. In contrast, Firm D has a harder time borrowing due their limp credit rating. It wishes to borrow longterm at a fixed rate, which it can do directly in the fixed-rate bond market at 11%. Alternatively, it could borrow floating interest rate funds at 1.25% over LIBOR. Suppose that Firm C and Firm D enter into an interest rate swap and split the cost savings equally. Q. After the swap, what rate would Firm D be paying for its fixed rate funds?

Answer 1

	Calculation of rate paid by Firm D for Fixed rate fund
	Fixed rate for firm D without swap				11%
Less;	Saving due to Swap(NOTE C)/2*				0.50%
			Net rate		10.50%
	*The saving due to swap is shared equally by both firms.
Notes
(A)	Total cost of funds without swap for both the firms
	Firm C (Floating rate preference)				LIBOR+0.25%
	Firm D (fixed rate preference)				11%
			Total		LIBOR+11.25%
(B)	Total cost of funds with swap for both the firms
	Firm C (Borrow fixed rate funds under swap)				9%
	Firm D (Borrow floating rate funds under swap)				LIBOR+1.25%
			Total		LIBOR+10.25%
(C.)	Total saving for both the firms due to swap
		A-B	=	1%
(D)	Under Swap agreement,the firm C will buy fixed rate funds because it has MORE advantage
	in buying fixed rate fund than floating rate fund as compared to firm D.
	The other reason is that if firm C buys floating rate,the swap agreement would not take place