Question

International Oil plc is interested in raising £100 million in order to carry out further oil exploration. International oil is an AA-rated company and, as such can borrow for 12 months at a fixed rate of 12 per cent or a floating rate of LIBOR +30 basis points.

London Property Ltd has a lower credit rating, and wishes to raise a similar sum for investment in the housing market. London Property can only borrow at a fixed interest rate of 14 per cent and a floating rate of LIBOR + 80 basis points

Security Pacific Bank has been recommended as the best continuous swap managers and the keenest on price. For arranging a swap, a fee of £50,000 is payable by each party.

Assume International Oil desires floating-rate debt and London Property desires fixed-rate debt.

International Oil London Property

Fixed-rate 12% 14%

Floating-rate LIBOR +0.3% LIBOR + 0.8%

1. Develop an interest rate swap in which both companies have an equal cost savings in their borrowing costs?
2. How much (£) International Oil plc gains from swap?

Answer 1

Interest rate swap won't work in this case since the cost of borrowing is higher for London Property for both Fixed Rate and Floating Rate loans. The two companies could benefit from entering into a swap if one of them had a lower rate if borrowing fixed rate (but actually wanted to borrow floating rate) and the other party had a lower rate if borrowing floating rate (but actually wanted to borrow fixed rate).