Nero Fiddle Company and Caesar Grape Exporters face the following interest rates

Question

Nero Fiddle Company and Caesar Grape Exporters face the following interest rates:

Fixed Rate

Floating Rate

Nero

5.0%

LIBOR + 0.5%

Caesar

6.5%

LIBOR + 1.0%

Suppose that Nero borrows at the fixed-rate and Caesar borrows at the floating-rate. A financial institution arranges a swap and earns a 50-basis point spread as its fee. Nero receives 5% fixed and pays LIBOR + 0.25% to the financial institution. Caesar receives LIBOR + 1% and pays 6.25% fixed to the financial institution.

a) What are the net payments for Nero and Caesar if they engage in the swap?

b) Will Nero be better off to borrow at a floating-rate or to borrow on a fixed-rate note and engage in the swap? If so, by how much?

c) Will Caesar be better off to borrow on a fixed-rate note or to borrow at a floating-rate and engage in the swap?

Fixed Rate

Floating Rate

Nero

5.0%

LIBOR + 0.5%

Caesar

6.5%

LIBOR + 1.0%

Explanation / Answer

a) Nero: Borrows -5.00% Receives from the Institution 5.00% Pays to the institution -(LIBOR+0.25%) Net rate -(LIBOR+0.25%) Caeser: Borrows -(LIBOR+1.00%) Receives from the Institution (LIBOR+1.00%) Pays to the institution -6.25% Net rate -6.25% b) If Nero borrows at floating rate directly, the interest would be LIBOR+0.5%, whereas imder the swap, it has to pay a net interest rate of LIBOR+25%, which will yield a net gain of 0.25%. Hence, it will be better off borrowing on a fixed rate note and engaging in the swap. C) If Caeser borrows at floating rate directly, the interest would be 6.5%, whereas imder the swap, it has to pay a net interest rate of 6.25% which will yield a net gain of 0.25%. Hence, it will be better off borrowing on a floating rate and engaging in the swap.

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