Question

Problem 7.12.* Companies A and B face the following interest rates (adjusted for the differential impact of taxes): US Dollars (floating rate) Canadian dollars (fixed rate) LIBOR+0.5% 5.0% LIBOR+1.0% 6.5% 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?

Answer 1

Answer:

A has lower rates in both floating and fixed terms which means they have an absolute advantage.

But A has more advantage in the fixed market as compared to B, means A has a comparative advantage in the fixed market.

Therefore, A will borrow at a fixed rate and swap their position with B (to float) with the help of financial institution.

B will borrow at a floating rate and swap their position with A (to fixed) with the help of the financial institution.

Net Saving Possible : (6.5% - 5%) - (L+ 1% -(L+ 0.5%)) = 1 %

Of this 1%, 0.5% will be taken by financial institution and rest 0.5% is the saving that both party can make by going into swap.

Please check the calculation below:

Saving For A = 0.25%

Rate for A = L + 0.25%

Saving For B = 0.25%

Rate for B = 6.25%

Total Saving = 0.5%

F I will inform B that they have a party offering 6.261. fixed rate (including. I Ainform FI that they want to convert their fix position to float. They will provide fixed interest rate of 6010 6010 spread of 0.25% FINANCING 6.25010 500 fixed > A INSTI- TUTION Yok Uibort1 Liborti. 25 A will borrow at Solo fixed. A wants to conuut their fix position to float Rates For A pay at 500 receive at +6 010 payat - L +1.25 FI w inform A that they have a party offering L+1:2500 float rate Cineluding spread OF 0.25.10 ) Built borrow at Libort ido 3 will inform C Floating C FI that they want to conuert their floating position to fixed They will offer flout interest rate of Libort 1 Rates for B pay at -lt lolo) receiveat tet lolo) pay at 6.25 6. 25.1. fixed saving = 6.5-6.25 = 0.25% [L+0.25 ] floating spread of FI y 0.25 from B 0.25 from A 10-5010 ] Saving Lt0.5-L-0.25 = 0.25%

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