Interest Rate Swaps

1) Company A has outstanding debt on which it currently pays fixed rate of interest at 9.5%. The company intends
to refinance the debt with a floating rate interest. The best floating rate it can obtain is LIBOR + 2%. However, it
does not want to pay more than LIBOR. Another company B is looking for a loan at a fixed rate of interest to
finance its exports. The best rate it can obtain 13.5%, but it cannot afford to pay more than 12%. However, one
bank has agreed to offer finance at a floating rate of LIBOR + 2%. Citibank is in the process of arranging an
interest rate swap between these two companies.
a. With a schematic diagram, show how the swap deal can be structured,
b. What are the interest saving be each company?
c. How much would Citibank receive?
Solution:
First let us tabulate the details to find the quality spread differential:
Cost of Funds to Company A and B

Objective Fixed rate Floating rate

Company A Floating 9.50% p.a. Libor + 200bp

Company B Fixed 13.50% p.a. Libor + 200bp

Differential 400 bps 0bps

The differential between the two markets = 400 bps – 0 = 400 bps. A total of 400 bps needs to be shared
between A, B and Citibank. Since A cannot afford to pay more than Libor, it needs 200 bps benefits out of the
total 400 bps (Libor + 2% - Libor). Similarly B cannot pay more than 12% as against the existing available fixed
rate funding of 13.5, it requires 150 bps benefits out of 400 bps. The balance 50 bps would be shared / charged
by the Citibank. The swap can therefore be structured as follows:

Firm Paid to Bank Received from bank Paid to market Net Cost Savings

A Libor 9.5% 9.5% Libor (Libor + 2%) – (labor) = 200 bps

B 10% Libor Libor + 200 bps 12% (13.5 – 12.0) = 150 bps
 Company A gets floating rate funds at Libor as against Libor + 2%, thereby getting an advantage of 200 bps,
Company B gets fixed rate funds at 12% as against 13.5%, thereby getting an advantage of 150 bps and finally
Citibank gets 50 bps commission.

2) Companies A and B have been offered the following rates per annum on a $ 20 million 5 – years loan:
Fixed Rate Floating Rate

Company A 12.0% LIBOR + 0.1%

Company B 13.4% LIBOR + 0.6%

Company A required a floating rate loan; company B required a fixed rate loan. Design a swap that will net a
bank, acting as an intermediary, 0.1% per annum and which will appear equally alternative to both companies
Solution:
Let x be the spread in the fixed rate market (in this case 140 basis points) and let y be the spread in the floating
rate market (50basis points). The total gains available is x-y = 90 basis points. The bank will take 10 basis points,
so that leaves 80 basis points to be split equally between A and B. Therefore, A must end up paying LIBOR – 30
basis points and B must end up paying 13%. One way to accomplish this is as follows:
A Pay 12% to outside lenders

Pay LIBOR – 0.1% to the bank in the swap

Receive 12.2% from the bank in the swap

Total 12% + LIBOR – 0.1% - 12.2% = Libor – 0.3%

B Pay LIBOR + 0.6% to outside lenders

Pay 12.2% to the bank in the swap

Receive LIBOR – 0.2% from the bank in the swap

Total LIBOR – 0.6% - 12.2% -( Libor – 0.2%) = 13%

Note that the bank profits of 10 basis points come from receiving LIBOR – 10 basis points from A and paying
LIBOR – 20 basis points to B.

3) Following information is available for two firms

Firm Objective Fixed Rate Floating Rate
A Floating Rate 10% L+0.75%
B Fixed Rate 11% L+1%
Explain how the two firms would enter into a swap transaction to reduce their interest costs, if A does not want
to pay more than L+0.35%
Solution: This a case of interest rate swap without a bank intermediary.
Step1: Find the interest differential in fixed market. Here it is 100 bps
Step 2: Find the interest differential in floating market. Here it is 25 bps.
Step3: The quality spread is 75 bps (100-25)
Step 4: A’s objective is to go for floating payment but wants to pay L+35bps. In other words, as against the
market cost of L+75 bps it wants to pay L+35 bps implying a savings of 40bps. Out of possible 75 bps (quality
spread) B would save 35 bps i.e., B’s cost would be 10.65%.
4) Company X wishes to borrow U.S. dollar at a fixed rate of interest. Company Y wishes to borrow Japanese yen at
a fixed rate of interest. The amount required by the two companies are roughly the same at the current
exchange rate. The companies have been quoted the following interest rates:
Yen Dollar

Company X 5.0% 9.6%

Company Y 6.5% 10.0%

Design a swap that will net a bank, acting as an intermediary, 50 basis points per annum. Make the swap appear
equally attractive to the two companies.
Solution:
Let x be the spread in the fixed rate market (in this case 150 basis points) and let y be the spread in the dollar
market (40basis points). The total gains available is x-y = 110 basis points. The bank will take 50 basis points, so
that leaves 60 basis points to be split equally between X and Y. Therefore, A must end up paying 9.3%in dollar
and B must end up paying 6.2% in yen. One way to accomplish this is as follows:
X Pay 5% in yen to outside lenders

Pay 9.3% in dollar to the bank in the swap

Receive 5% in yen from the bank in the swap

Total 9.3% in dollars

Y Pay 10% in yen to outside lenders

Pay 6.2% in to the bank in the swap

Receive 10% in dollar from the bank in the swap

Total 6.2% in yen

Note that the bank profits of 50 basis points come from receiving 6.2% and paying 5% in yen (thereby gaining
120 basis points in yen) while receiving 9.3% and paying 10% in dollar (thus losing 70 basis points in dollars).
Also, the final exchange of principle will expose X and Y to exchange rate risk, but not the bank.

5) Two companies A & B have identical dollar borrowing requirements. A prefers floating rate funding and B fixed
rate funding. The interest rates applicable to A & B are as given below.
Company Floating Fixed

A LIBOR + 0.5% 10%

B LIBOR + 1.5% 12%

Explain how they can use an interest rate swap profitability without an intermediary
Solution:
A has a absolute advantage of 1% in the floating rate and 2% in the fixed rate market. If A accesses the fixed
rate markets and B the floating rate markets and B the floating rate markets, the net advantage for A & B will be
2% - 1% Let us assume that the benefit of 1% is shared equally between A & B. Then the deal can be structured
as explained below:
A borrows in the fixed rate market (10%) & B borrows in the floating rate market ( Libor + 1.5%).
Also,
A pays B = 10.5%
 B pays A = Libor + 0.5%
Effective cost of funding for A = 10 + LIBOR + 0.5% - 10.5% = LIBOR
Benefit to A = Libor + 0.5% - Libor = 0.5%
Effective cost of funding for B = 10.5 + LIBOR + 1.5% - (LIBOR + 0.5%) = 11.5%
Benefit to B = 12% - 11.5% = 0.5%
Note that A has borrowed fixed rate funds but has successfully converted repayment into a floating rate liability.
B has done exactly the reverse.

6) In the above problem, assume that an intermediary is needed to structure the deal. The intermediary wants a
spread of 0.2%. Explain how the deal can be structured, assuming again that the net benefit is shared equally
between A & B.
Solution:
The deal can be structured as indicates below.
Net cost of funding for A
= 10 + LIBOR + 0.5% - 10.4% = LIBOR + 0.1%
Net cost of funding for B
= 10.5% + LIBOR + 1.5% - (LIBOR + 0.4%) = 11.6%
Benefit to intermediary
= - (LIBOR + 0.4 + 10.4) + (LIBOR + 0.5% + 10.5%)
= 0.2%