Companies A and B face the following interest rates (adjusted for the differenti

Question

Companies A and B face the following interest rates (adjusted for the differential impact of taxes):

Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants to borrow Canadian dollars at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 50-basis-point spread. If the swap is equally attractive to A and B, what rates of interest will A and B end up paying?

Explain in detail.

A B US dollars (floating rate) LIBOR + 5% LIBOR + 1.0% Canadian dollars (fixed rate) 5.0% 6.5%

Explanation / Answer

Solution :-

Company A wants US Floating Rate Company B wants Canadian Fixed Rate With out Swap Company A US dollar Floating Rate LIBOR + 5% Compnay B Canadian Dollar Fixed rate 6.50% Total Interest paid by both LIBOR + 11.5% After the Swap Agreement Both company can take loan for eachother Company A Canadian Dollar Fixed rate 5% Compnay B US dollar Floating Rate LIBOR + 1% Total Interest paid by both LIBOR + 6% Therefore net profit of interest due to wap agreement = LIBOR + 11.5% - (LIBOR + 6%) = 5.50% The Spread paid to financial institution who arranged Swap = 0.50% Net profit to both the companies of interest = 5% Share of Company A in interest profit = 2.50% Share of Company B in interest profit = 2.50% Rates of interest at which company A and B end up paying Company A US dollar Floating Rate LIBOR + 5% - 2.5% = LIBOR + 2.5% Compnay B Canadian Dollar Fixed rate 6.5% - 2.5% = 4%

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