Company A is a AAA-rated firm wanting to issue five-year FRNs. It determines that it can issue FRNs at six-month LIBOR + 1/8 percent or at the six-month Treasury-bill rate + ½ percent. Specified its asset structure, LIBOR is the preferred index. Company B is an A-rated firm which also yearning to issue five-year FRNs. It determines that it can issue at six-month LIBOR + 5/8 percent or at the six-month Treasury-bill rate + 1 5/8 percent. Given its asset structure, the six-month Treasury-bill rate is the preferred index. Suppose a notional principal of $15,000,000. Find out the QSD and set up a floating-for-floating rate swap where the swap bank receives 1/8 percent & the two counterparties share equally the remaining savings.
The quality spread differential is [(T-bill + 1 3/8 percent) minus (T-bill + 4/8 percent) =] 9/8 percent minus [(LIBOR + 5/8 percent) minus (LIBOR + 1/8 percent) =] 4/8 percent, that equals 5/8 percent. If the swap bank attains 1/8 percent, each counterparty is to save 2/8 percent. Company B would issue LIBOR indexed FRNs. Company A would issue Treasury-bill indexed notes. Semi-annual payments will be created through both counterparties to the swap bank. On an annualized basis, Company B will remit to the swap bank the T-bill rate + 11/8 percent & pay LIBOR + 5/8 percent on its FRNs. It will attain LIBOR + 5/8 percent from the swap bank. This arrangement results in an all-in cost of the T-bill rate + 11/8 percent, that is a rate 1/4 percent below the T-bill indexed FRNs Company B could issue on its own. Company A will remit LIBOR + 5/8 percent to the swap bank and pay the T-bill rate + 4/8 percent on its FRNs. It will attain the T-bill rate +10/8 percent through the swap bank. This arrangement results in an all-in cost of LIBOR - 1/8 percent for Company A, that is 1/4 percent less than the LIBOR indexed FRNs it could issue on its own. The arrangements along with the two counterparties net the swap bank 1/8 percent per annum, received semi-annually.