Company A and B can borrow for a 3-year term at the following rates. While A des

Question

Company A and B can borrow for a 3-year term at the following rates. While A desires fixed rate borrowing, B prefers floating rate borrowing.

       Fixed Rate Floating Rate

A     8.5%            LIBOR + 0.5%

B     7%        LIBOR

The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.5%.

Illustrate how Company A benefits from the use of interest rate swap.

Summarize the risks taken by the swap bank in the interest swap with Company B.

Is it feasible for the swap bank to customize an interest rate swap that provide a cost saving of 0.35% to B? Explain.

Suppose both Company A and B 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.

Explanation / Answer

Ans;

1.For A the fixed rate is 8.5%, whereas if it enters into a interest rate swap with a bank,bank will pay floating interest whereas A will pay fixed rate.Bank enteres into floating rate paying swap as it forcasts the libor rates to go down in future, thus benifiting from lower interest rate.A forcasts interest rate on libor to increase and hence enters into the agreement.Bank charges a fee for the same.With floating rate the interest rate comes to 7.25 to 7.5% , which is more than 1% less than fixed rate of 8.5%, thus bank benifits with this swap at this point in time.

2.Company B will be oaying floating leg of the swap which is 7.25 to 7.5%, so the risk for bank B will be increase of libor rates, if libor rates increase floating leg payments will increase.

3.with using quoted swaps B will not have to pay the bank charge gor the agreement, rather it can directly enter into exchange market abd get the swap spreadmbut most of the swap agreements are OTC and not exchange traded.

4.The company A will be willing to unwind its position as its paying fixed rate of 8.5%, whereas floating rate has gone down to 6.5 to 7%, so it will pay around 1.5 to 2% to unwind its position.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.