Question

--- ------ -JUU UUDIU yivel UIU CURStraints in c? 2. Use the information on the current cost of financing for Company AAA and Company BBB in the following table to answer the questions below (20 minutes). Show all work. AAA BBB 5-Year Fixed-Rate Financing Treasury + 20 Treasury + 210 Floating Rate Financing LIBOR + 10 LIBOR + 60 a. Determine which company has the comparative advantage in fixed-rate debt. b. Calculate the ultimate borrowing costs for AAA and for BBB if these two entities borrow in the debt market in which they have a comparative advantage and then enter into a fixed- for-floating interest rate Swap agreement where AAA pays LIBOR to BBB and BBB pays Treasury +80 to AAA. c. Refer back to Company X in question 1. Determine which side of the swap transaction described above (AAA's or BBB's) Company X should take in order to immunize its balance sheet. Fully explain your answer. d. Using Dollar Duration Gap analysis, if an investment bank were to offer a 5-year duration interest rate swap, what notional amount of this swap should Company X obtain to fully immunize its balance sheet? e. The above swap transaction is often referred to as "interest rate arbitrage". Explain why this transaction is not a true arbitrage transaction.

Answer 1

Company	Fixed Rate Treasury+	Floating Rate LIBOR +
AAA Corp	20	10
BBB Corp	210	60
Difference	190	50

As we know that the comparative advantage means if two parties join hands and wants to do a trade/swap at lowest total cost.

If we need to know the company with comparative advantage in a category then we need to compare the difference for both the companies in each category (190 and 50). From above table we can see that the category in which the difference is highest (i.e. Fixed Rate) that category's lowest cost of borrowing must be selected as it will reduce the overall cost of borrowing.

Thus for Fixed Rate AAA Corp has a comparative advantage as the benefit is higher(difference is higher).

From the above table we can see that AAA Corp has absolute advantage over BBB. Thus now arranging cash flow we get following:

AAA Borrows on Fixed Rate at (Treasury + 20) It then pays (LIBOR) to BBB and receives (Treasury + 80) from BBB. The net Cash Outflow is (Treasury + 20 ) + LIBOR -(Treasury + 80) = LIBOR - 60

Borrowing Cost for AAA is LIBOR-60

BBB borrows on Floating rate at (LIBOR +60) It then pays (Treasury + 80) and receives (LIBOR) from AAA. The net Cash Outflow is (LIBOR + 60) + (Treasury + 80) - LIBOR = Treasury + 140

Borrowing Cost for BBB is Treasury + 140