1. Discuss the basic motivations for a counterparty to enter into a currency swap.
2. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assume that a swap bank is involved as an intermediary and the bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.
Alpha and Beta Companies can borrow for a five-year term at the following rates:
Alpha Beta
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
(a) Calculate the quality spread differential (QSD).
(b) Graph the swap including the external financing costs.
(c) What is the all-in interest rate cost for each of the firms?
(d) How much does the swap bank make (in terms of interest rates)?
(e) How much does each firm save per year?
(f) Assume Alpha and Beta want to borrow $ 100,000,000 for 5 years. Further, the LIBOR rate over the next 5 years is expected to be 7%. Report the net borrowing costs (in dollar terms, not interest rates) for both parties.