4. Two years ago, Company A arranged a long-term loan of £15m at fixed interest

Question

4. Two years ago, Company A arranged a long-term loan of £15m at fixed interest of 2 per cent per annum to finance the expansion of its business Interest rates have been falling over the past two years and Company A realises, in hindsight, it would have been paying less interest if it had taken a variable rate loan. Because it does not expect interest rates to increase in the foreseeable future and believes it more likely they will fall further, it would like to alter its arrangements to a loan at a variable interest rate of Libor plus 1 per cent, the rate it has been quoted in the market. Company B took out a variable rate loan, also two years ago for £15m, at interest of Libor plus 0.5 per cent. Company B has benefited from the falling interest rates but now has the view that rates will start to increase again over the next year. Therefore it would like to alter its arrangements to a loan at a fixed rate of interest. Unfortunately B's credit rating has deteriorated in the intervening period and the rate it has been quoted in the market is 2.5 per cent. Both companies have three years outstanding on their loans and a bank has said it could arrange to swap the companies' commitments for which it would require a fee of 0.25 per cent per annum of the amount of the loan, payable by each company until their loan is repaid. Each company would benefit equally from the swap a) Set out the transactions that would take place showing how each party would benefit from the swap [8 marks] b) What unusual features does this transaction have compared to the more normal case where newly raised loans are swapped? [2 marks]

Explanation / Answer

A) Now, the transactions would be like,

Company A's fixed 2% interest would be swapped with LIBOR + 0.5% of company B.

The net benefit = (LIBOR + 1%) - (LIBOR + 0.5%) + (2.5% - 2%)

= 1%

So, net benefit after banks take = 1%-0.25% = 0.75%

So, benefit to company A and B respectively = 0.75/2 = 0.375%

B) The unusual feature is that in this case the loan is already granted. There is a swap with ongoing payments. The loan has already been taken and now with the loan payments of 3 years pending, the pending payments are being swapped. In usual loans, the entire payments are swapped.

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