A company issues a bond with a 5 year maturity and will have to make an annual p

Question

A company issues a bond with a 5 year maturity and will have to make an annual payment of LUBOR+ 1.5% to the bondholders. Exp lain (show your calculations) how the company can use the swap rates below (provided by a bank) to convert these payments to fixed-rate payments for an appropriate time horizon. Swap Quotes (percent per annum) Maturity (yrs) Bid Offer Swap Rate 6.21 6.24 6.225 6.47 6.51 6.490 6.65 6.68 6.665 7 i) Briefly explain if the company will benefit or lose mortey if it enters the swap agreement and the LIBOR stays at 6.49% on average during the 5 year period.

Explanation / Answer

1)

Issued Bond for 5 years with an annual coupon payment of Libor + 1.5%

Term of Swap 5 years
Pay Fixed: 6.49% Annually on the notional
Receive Floating: Libor + 1.5% on the Notional

Now we know that the company issued a bond for 5 years on a floating coupon payment of Libor + 1.5%. Now the company needs to convert the floating payment into fixed payments. For this the company enters into a swap. Among the 3 rates given we would choose 5 year maturity swap as a bond is also for 5 years. The Swap rate is also provided of 6.49% annually to be paid on the notional amount. The Swap notional will be equal to the amount for which the bonds is issued for. This will help in equating the asset and liability.

so the calculation will be as shown below for the next five years.

A Pay (Libor + 1.5%) as interest payment for the Bond issued on the Loan amount.

B. Receive Libor +1.5% as interest Payment for the swap on the notional amount.

C Pay 6.49% as interest payment for the swap on the notional amount.

We will deduce from the above payment that net payout is Fixed payment of 6.49% which helps in converting the floating payment to fixed payment for the bond issued.

2)

Assuming the LIBOR stays at 6.49% for next 5 years.

So the floating payment would be Libor + 1.5%= 6.49%+1.5%= 7.99%

The Fixed payment is 6.49% for 5 years. So Fixed payment < Floating Payment (6.49% < 7.99%).

So the company will benefit if it enters into a swap agreement.

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