Company Y and Z can borrow $40 million for a 3-year term at the following rates.
ID: 2717211 • Letter: C
Question
Company Y and Z can borrow $40 million for a 3-year term at the following rates. While Y desires fixed-rate borrowing, Z prefers floating-rate borrowing.
Fixed-Rate
Floating-Rate
Y
8.5%
LIBOR+0.5%
Z
7%
LIBOR
The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.50%.
QUESTIONS (THERE ARE TOTALLY 3 QUESTION, Please do with detailed calculation process )
(1) Illustrate how Company Y benefits from the use of interest rate swap.
2Summarize the risks taken by the swap bank in the interest swap with Company Z.
3Suppose the swap bank does not customize interest rate swaps. Is it possible for Company Z to get a cost saving of 0.35% from the use of quoted swaps? Explain.
4Suppose both Company Y and Z entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5-7%. Which company is willing to unwind the original swap? Explain. How much it is willing to pay to unwind?
Fixed-Rate
Floating-Rate
Y
8.5%
LIBOR+0.5%
Z
7%
LIBOR
Explanation / Answer
1) The Swap can be arranged through the swap bank as below:
Y Pays to bank 8.5 Z receives from bank 7.5%
COMPANY - Y SWAP -BANK COMPANY - Z
Y receives from Bank L+0.75 Z pays to bank L
Borrows @ L+0.05 Borrows @ 7.0
Company - Y : Pays L+0.5 and 8.5, gets back L+0.75. Effective rate = 8.25%.
Had it gone for direct borrowing at fixed rate it would have paid 8.5%. Thus, Y has gained 0.25%
2) If Z defaults, Bank will lose the margin of 0.75 % and will incur a loss of 0.5%.
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