Question

3. Corporate loans are usually floating-rate liabilities. A firm's liability consists of $1 Billion 3-year loan that carries an interest of LIBOR+1.5%. The interest is pain annually. a. What is the risk associated with this loan? How does a 1% increase in LIBOR impact firm's pre-tax income? b. The company decides to use the LIBOR swap quotes in the following table to manage this risk. What fixed rate will the company pay on its 3-year loan? Maturity 1-Year 2-Year 3-Year 4-Year 5-Year LIBOR swap rate 1.66% 1.46% 1.38% 1.37% 1.35%

Answer 1

Q3 a) The risk associated with this loan is that the interest on loan is based on Libor. An increase in Libor over the period will lead to increase in the amount of interest to be paid on the loan.

A 1% increase in Libor will increase the amount to br paid as interest by 1%. As interest paid is an expense and needs to be deducted while calculating net income, it decreases the amount of pre tax income.

B) In order to reduce its risk company enters into 3year swap which has a fixed rate of 1.38%. This is because the maturity of the loan is 3 years. Entering into swap will decrease its risk if interest rates rise and increase the risk if interest rates fall. But in this case the company is still under profit because it had to pay Libor + 1.5% which is still higher than 1.38% even if the interest rates fall.