Suppose company ABC has a 10-year fixed-rate debt $200 M with an annual interest
ID: 2755999 • Letter: S
Question
Suppose company ABC has a 10-year fixed-rate debt $200 M with an annual interest rate of 8 %. Bank XYZ has an average floating-rate liability of $150M. The floating rate is the market prime rate (call it r). What kind of risks do ABC and XYZ face? To hedge the risk, ABC and XYZ get in an interest rate swap with a dealer D for a nominal principal of $150M for the next ten years. As a result, D agrees to pay ABC 7.9 % annually. ABC agrees to pay D the market rate r. D also agrees to pay XYZ the market rate r, and XYZ agrees to pay D 7.95% annually. What have these swap transaction achieved for ABC, XYZ and D? If the market interest rate is 7.5 % in year 2, who benefits from doing the swap? Who suffers a loss? Explain Why.Explanation / Answer
(1)
ABC faces the risk of market interest rate going below 8% which means they're paying higher interest than warranted by market condition.
XYZ has the risk that 'r' increases, resulting in higher interest liability.
(2)
ABC: Receives 7.9% and pays r, eliminating the risk of downward movement of interest rate.
XYZ: Receives r and pays 7.95%, eliminating the risk of upward movement of interest rate.
D: Nets (7.95 - 7.7)% = 0.05% of $150M = $75,000 gain.
(3)
Market interest rate in year 2 is 7.5%.
Since A has entered into a swap of interest rate locked at 7.9%, A will be a loser.
B will gain because the lower the interest rate, the more B gains.
D will remain in a neutral position.