Response to the following problem:
Suppose that Chuckie Munchies Company is seeking to raise $60 million for the next five years on a fixed-rate basis. The firm's investment banker indicates that if bonds with a maturity of five years are issued, the interest rate on the issue would have to be 9%. At the same time, there are institutional investors willing to purchase a bond whose annual interest rate is based on the actual performance of the S&P 500 stock market index. Specifically, the company can issue a five-year bond whose coupon rate is equal to the S&P 500 minus 250 basis points.
a. If Chuckie Munchies Company issued a bond whose coupon rate is tied to the S&P 500, what risk is it facing?
b. Suppose that the company's investment banker indicates that the firm can enter into a five-year equity swap with a notional amount of $60 million on the following terms:
¦ One party will pay a fixed-rate of 8.7%.
¦ The other party will pay a rate equal to the actual performance of the S&P 500 minus 280 basis points (with the minimum interest rate equal to zero). How can Chuckie Munchies Company's CFO use the equity swap to create a bond structure tied to the S&P 500 so as to lower its funding cost?