Each of two companies decides to issue $10 million in 5-year debt on the same da

Question

Each of two companies decides to issue $10 million in 5-year debt on the same date. Each company consults its investment banker to consider alternatives. Market conditions are the following:

• Company C has told its banker that it desires a fixed rate liability.

• Company C is advised that it can probably issue notes in a fixed rate structure at 4.30% or on floating rate terms at LIBOR + 90 bps.

• Company D has told its banker that it desires a floating rate liability.

• Company D is advised to expect a market rate of 4.85% for its fixed rate debt and LIBOR + 150 basis points (bps) for its floating rate debt.

• The banker also checks the swap market on each customer’s behalf. In an email to each customer, the banker notes the best terms in the dealer market on a standard US dollar swap for a 5-year fixed-for-floating swap:

Dealer PAYS 3.28% fixed to customer vs. RECEIVING LIBOR from customer

OR

Dealer RECEIVES 3.32% fixed from customer vs. PAYING LIBOR to custo

Identify the swap dealer’s risk position and profitability on its swap book after each company follows its banker’s advice: A.   Fully hedged: no risk to a change in LIBOR and making a 4 basis point spread B.    Not hedged at all, will lose money if LIBOR decreases dramatically, and should buy some Eurodollar futures as a hedge C.    Not hedged at all, will lose money if LIBOR increases dramatically, and should sell some Eurodollar futures as a hedge D.    Not hedged at all, will lose money if LIBOR increases dramatically, and should buy some Eurodollar futures as a hedge

Explanation / Answer

Ans is D Not hedged at all, will lose money if LIBOR increases dramatically, and should buy some Eurodollar futures as a hedge because he is getting 4 basis point on fixed loan exchange but has to pay 60 basis point on LIBOR. Hence when LIBOR increases he will be in loss hence he should buysome European future hedge.

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