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Understanding the Savings using a Standby Letter of Credit (SLC)

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A corporation is planning to issue $1,000,000 of 270-day commercial paper for an effective yield of 5%. The corporation expects to save 30 basis points on the interest rate by using either an SLC or a loan commitment as collateral for the issue:

What are the net savings to the corporation if a bank agrees to provide a 270-day SLC for an up-front fee of 20 basis points to back the commercial paper issue?

Please explain the concepts.

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Solution Summary

The solution provides an excellent understanding of the concepts of using an SLC and the fees charged for the risk involved.

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Companies often issue CP's to finance their short term requirements. These are generally for less than a year.

In this problem, company is in need of $1,000,000 and might be expecting some cash flow (which is substantially more than a million dollars) in 270 days time.

Now, people at large are not sure whether the company would pay or default, so they ...

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