Assume the following interest rates at which firms A and B can borrow: Also assu
ID: 2743408 • Letter: A
Question
Assume the following interest rates at which firms A and B can borrow:
Also assume that A ultimately wants a floating rate loan while B wants a fixed rate loan. Design an interest rate swap so that both can benefit. Estimate the profit for firm A and firm B in your design.
[Hint: There is no dealer involved. So, it is actually easier than the example in book. Start with drawing a swap diagram for two parties. Use arrows to show the flow of interest. Also, make sure that profits of A and B add up to the net profit from the swap]
Fixed Rate Floating rate Firm A 8% LIBOR+1% Firm B 9% LiBOR+1.6% Premium paid by B over A 1% .6%Explanation / Answer
Answer
Particulars
Firm A
Firm B
Difference
Fixed rate
8%
9%
1%
Floating rate
Libor+1%
Libor+1.6%
-0.60%
Net profit
0.40%
Profit of Firm A
(0.4%/2)
0.20%
Profit of Firm B
(0.4%/2)
0.20%
Total Net Profit
0.40%
Swap Design
Firm B will borrow floating rate loan at Libor+1.6% and will give loan to Firm A at Libor+0.8% ( i.e. Libor+1% - 0.2%). So Firm A will get benefit of 0.2% on floating rate loan.
Firm A will borrow fixed rate loan at 8% and will give loan to Firm B at 8.8% (i.e. 9% - 0.2%). So Firm B will get benefit of 0.2% on fixed rate loan.
Particulars
Firm A
Firm B
Difference
Fixed rate
8%
9%
1%
Floating rate
Libor+1%
Libor+1.6%
-0.60%
Net profit
0.40%
Profit of Firm A
(0.4%/2)
0.20%
Profit of Firm B
(0.4%/2)
0.20%
Total Net Profit
0.40%
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