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Swaps, arbitrage, interest rate swaps & hedging

1. Company A, a low-rated firm, desires a fixed-rate, long-term loan. Company A currently has access to floating-rate funds at a margin of 1.5% over LIBOR. Its direct borrowing cost is 13% in the fixed-rate bond market. In contrast, Company B, which prefers a floating-rate loan, has access to fixed-rate funds in the Eurodollar bond market at 11% and floating-rate funds at LIBOR + 0.50%.

How can A and B use a swap to advantage?

2. Explain how Cisco Systems can use arbitrage to create a forward forward to fix the interest rate on a three-month $10 million loan to be taken out in nine months. The loan will be priced off LIBOR. (Hint: Lecture Slide 18)

3. Explain why an interest rate swap is a useful tool for active liability management and for hedging against interest rate risk.

PLEASE EXPLAIN IN DETAIL and show any calculations.

Solution Preview

1. Company A, a low rated firm, desires a fixed rate, long term loan. Company A currently has access to floating-rate funds at a margin of 1.5% over LIBOR. Its direct borrowing cost is 13% in the fixed rate bond market. In contrast, Company B, which prefers a floating rate loan, has access to fixed rate funds in the Eurodollar bond market at 11% and floating rate funds at LIBOR + 0.50%.

How can A and B use a swap to advantage?

The two companies can use swap to their advantage by exchanging interest rates thus are able to acquire lower interest rate compared to what they could have attained. The two companies can gain from interest rate savings and this can do this by combining the loans they have access to. Company A has floating interest rate funds at 1.5% over LIBOR while Company B has floating rate funds at 0.5% over basis points thus the difference in credit quality between Company A and ...

Solution Summary

This solution provides assistance with the finance problems attached.

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