Alpha and Beta Companies can borrow at the subsequent rates.
Alpha Beta
Moody's credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
1. Calculate the Quality Spread Differential (QSD).
2. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Suppose Alpha desires floating-rate debt and Beta desires fixed-rate debt.
Solution:
1. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.
2. Alpha requires to issue fixed-rate debt at 10.5% and Beta requires to issue floating rate-debt at LIBOR + 1%. Alpha requires to pay LIBOR to Beta. Beta requires to pay 10.75% to Alpha. If this is completed, 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.