As Aa 10. Swaps swaps are financial contracts between parties to exchange cash f

Question

As Aa 10. Swaps swaps are financial contracts between parties to exchange cash flows at specfied times and are based on an underlying asselt's value s waps allow companies to match the variablity of its interest payments with that of its cash flows. This heips to: O Increase risk Decrease risk Consider the case of Company A and Company & Company A Company B Company B is a bank Company A is a financing company . Company A has 30% debt in its capital structure, out of which 55% is floating-rate debt indexed to the LIBOR (London interbank ofered rate). Company A financed company C and eams a fixed ompany B gives its depositors an average of 6% foxed returm on the 10 million certificates of deposit in the bank The bank tends money to corporations at Rosting rates indexed to the LIBOR interest of 8% per annum. The financing company agrees to pay fixed-rate obligations to the bank, and the bank pays the financing company loating-rate payment based on LTBOR Company A and Company B enter into an interest rate swap agroement with each other for three years, Six months into the contract, uBOR decreases by 0.50%. Which of the two companies will benefit from the protoction that the swap provides? O Company O company B eams floating inberest that is indexed to the LtBOR but has to pay fixed interest on This is because ts debt. So f uBOR decreeses, the company earns less but wil have to pay the same interest on its debt. Because the cormpanies got into an interest rabe swap in which rate,n decrease in LTBOR would mean more interest earnings from the swap in the form of fixed interest that balances the dscreased samings from the fRosting interest rake would pay the other company a fixed interest Another klnd of swap is acredt default swap. A redZ default swatcs) is ?? contract that transes credit risk tom one counterparty tprobection buver) to pnother counterparty tprotection seller) Which party is required to post colloterat to suppart its peyment abligationz O Debt holder

Explanation / Answer

As per rules I will answer the first 4 subparts of the question

1.Decrease risk

(Swaps decrease risk by locking a fixed interest rate when the exposure is to varied interest rates)

2.Company B

(Company B will benefit since it has to pay fixed interest to depositors but receives money on funds lended based on LIBOR. If the swap was not there the company would have received a lower return)

3.This is because Company B earns floating interest that is indexed to the LIBOR.

4. Because the companies got into an interest rate swap in which Company A would pay the other company a fixed interest rate, the decrease in LIBOR means more interest earning from the swap.

(Since the decrease in rate is avoided, company B will have higher earnings due to the swap agreement)

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