Your firm needs to raise $100 million in funds. You can borrow short-term at a spread of 1% over LIBOR. Alternatively, you can issue 10-year, fixed-rate bonds at a spread of 2.50% over 10-year treasuries, which currently yield 7.60%. Current 10-year interest rate swaps are quoted at LIBOR versus the 8% fixed rate. Management believes that the firm is currently underrated and that its credit rating is likely to improve in the next year or two. Nevertheless, the managers are not comfortable with the interest rate risk associated with using short-term debt. a) Suggest a strategy for borrowing the $100 million. What is your effective borrowing rate? b) Suppose the firmâs credit rating does improve 3 years later. It can now borrow at a spread of 0.50% over treasuries, which now yield 9.10% for a 7-year maturity. Also, 7-year interest rate swaps are quoted at LIBOR versus 9.50%. How would you lock in your new credit quality for the next 7 years? What is your effective borrowing rate now?
Your firm needs to raise $100 million in funds. You can borrow short-term at a spread of 1% over LIBOR. Alternatively, you can issue 10-year, fixed-rate bonds at a spread of 2.50% over 10-year treasuries, which currently yield 7.60%. Current 10-year interest rate swaps are quoted at LIBOR versus the 8% fixed rate. Management believes that the firm is currently underrated and that its credit rating is likely to improve in the next year or two. Nevertheless, the managers are not comfortable with the interest rate risk associated with using short-term debt. a) Suggest a strategy for borrowing the $100 million. What is your effective borrowing rate? b) Suppose the firmâs credit rating does improve 3 years later. It can now borrow at a spread of 0.50% over treasuries, which now yield 9.10% for a 7-year maturity. Also, 7-year interest rate swaps are quoted at LIBOR versus 9.50%. How would you lock in your new credit quality for the next 7 years? What is your effective borrowing rate now?
Related questions
Company A and B can borrow $40 million for a 3-year term at the following rates. While A desires fixed-rate borrowing, B prefers floating-rate borrowing.
| Fixed-Rate | Floating-Rate | |
| A | 8.5% | LIBOR+0.5% |
| B | 7% | LIBOR |
The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.50%.
QUESTIONS (There are toally 4 questions):
(1) Illustrate how Company A benefits from the use of interest rate swap.
(2) Summarize the risks taken by the swap bank in the interest swap with Company B.
(3) Suppose the swap bank does not customize interest rate swaps. Is it possible for Company B to get a cost saving of 0.35% from the use of quoted swaps? Explain.
(4) Suppose both Company A and B entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5-7%. Which company is willing to unwind the original swap? Explain. How much it is willing to pay to unwind?
Company Y and Z can borrow $40 million for a 3-year term at the following rates. While Y desires fixed-rate borrowing, Z prefers floating-rate borrowing.
| Fixed-Rate | Floating-Rate | |
| Y | 8.5% | LIBOR+0.5% |
| Z | 7% | LIBOR |
The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.50%.
QUESTIONS (THERE ARE TOTALLY 3 QUESTION, Please do with detailed calculation process )
(1) Illustrate how Company Y benefits from the use of interest rate swap.
ï¼2ï¼Summarize the risks taken by the swap bank in the interest swap with Company Z.
ï¼3ï¼Suppose the swap bank does not customize interest rate swaps. Is it possible for Company Z to get a cost saving of 0.35% from the use of quoted swaps? Explain.
ï¼4ï¼Suppose both Company Y and Z entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5-7%. Which company is willing to unwind the original swap? Explain. How much it is willing to pay to unwind?
Alpha and Beta Companies can borrow for a five-year term at the following rates:
| Alpha | Beta | |
| Moodyâs credit rating | Aa | Baa |
| Fixed-rate borrowing cost | 10.5% | 12.0% |
| Floating-rate borrowing cost | LIBOR | LIBOR + 1% |
QUESTIONS: 2 questions
(1) Calculate the quality spread differential (QSD).
(2) Develop an interest rate swap on behalf of the swap bank, in which the swap bank will earn a
profit of 10 basis points. In addition, Alpha and Beta would have equal cost savings by doing the
swap. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.
