Alpha and Beta Companies can borrow at the described rates.
Alpha Beta
Moody's credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
Develop an interest rate swap wherein both Alpha and Beta contain an equivalent cost savings in their borrowing costs. Consider Alpha desires floating-rate debt and Beta desires fixed-rate debt.
Solution:
Alpha require to issue fixed-rate debt at 10.5% and Beta required to issue floating rate-debt at LIBOR + 1%. Alpha requires paying LIBOR to Beta. Beta required paying 10.75% to Alpha. If it is done, Alpha's floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floating-rate debt on its own. Beta's fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.