Alpha and Beta Companies can borrow for a five-year term at the following rates:

Question

Alpha and Beta Companies can borrow for a five-year term at the following rates:

                                                      Alpha                    Beta

Moody's Credit Rating                   Aa                         Baa

Fixed-rate borowing cost               10.0%                    12.5%

Floating-rate borrowing cost        LIBOR                       LIBOR + 1%

                a. Calculate the quality spread differential (QSD).

                b. Develop an interest rate swap in which a swap bank, Alpha and Beta share the savings equally if any. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. (10)

Explanation / Answer

a. The Quality Spread Differential =

(12.5% - 10.0%) minus (LIBOR + 1% - LIBOR) = 1.5%.

b. In the interest rate swap Alpha, Beta and the swap bank share the savings of 1.5% equally at 0.5%.

Swap arrangement:

The Net rate of borrowing and the gains are as follows:

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