Question

Company E presently has access to floating interest rate funds at a margin of 3% over LIBOR. Its direct borrowing cost is 12% in the fixed-rate bond market. In contrast, company F has access to fixed-rate funds at 11% and floating-rate funds at LIBOR+1%. Is the fixed rate or the floating rate the better deal for Company E?

Select one:

a. Fixed rate

b. Can't tell from the information given.

c. Variable rate

Answer 1

Based on the numbers presented, there is an anomaly between the two markets. Floating rate bond market suggests that the difference in credit quality between the two companies E and F is worth 200 basis points [(LIBOR+3)-(LIBOR+1)]%.

And the fixed bond market suggests that the difference in credit quality between the two companies is 100 basis points (12%-11%).

So, the difference of 100 basis points can be shared among the two companies by engaging in an interest rate swap. Hence, in order to do it, Company E should borrow floating rate bonds and company F should borrow fixed rate bond, and then swap the proceeds.