Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years.Their external borrowing opportunities are shown below: $$\begin{array} { l l l }
& \begin{array} { l }
\text { Fixed-Rate } \
\text { Borrowing Cost }
\end{array} & \begin{array} { l }
\text { Floating-Rate } \
\text { Borrowing Cost }
\end{array} \
\hline \text { Company X } & 10 \% & \text { LIBOR } \
\text { Company Y } & 12 \% & \text { LIBOR } + 1.5 \%
\end{array}$$ A swap bank proposes the following interest only swap: Y will pay the swap bank annual payments on $10,000,000 with a fixed rate of 9.90%.In exchange the swap bank will pay to company Y interest payments on $10,000,000 at LIBOR - 0.15%; What is the value of this swap to company Y?
A)Company Y will save 15 basis points per year on $10,000,000 = $15,000 per year.
B)Company Y will save 45 basis points per year on $10,000,000 = $45,000 per year.
C)Company Y will save 5 basis points per year on $10,000,000 = $5,000 per year.
D)Company Y will only break even on the deal.

Question

Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years.Their external borrowing opportunities are shown below: $$\begin{array} { l l l } 
& \begin{array} { l } 
\text { Fixed-Rate } \
\text { Borrowing Cost }
\end{array} & \begin{array} { l } 
\text { Floating-Rate } \
\text { Borrowing Cost }
\end{array} \
\hline \text { Company X } & 10 \% & \text { LIBOR } \
\text { Company Y } & 12 \% & \text { LIBOR } + 1.5 \%
\end{array}$$ A swap bank proposes the following interest only swap: Y will pay the swap bank annual payments on $10,000,000 with a fixed rate of 9.90%.In exchange the swap bank will pay to company Y interest payments on $10,000,000 at LIBOR - 0.15%; What is the value of this swap to company Y?
A)Company Y will save 15 basis points per year on $10,000,000 = $15,000 per year.
B)Company Y will save 45 basis points per year on $10,000,000 = $45,000 per year.
C)Company Y will save 5 basis points per year on $10,000,000 = $5,000 per year.
D)Company Y will only break even on the deal.

Quizplus · Accepted Answer

Before the swap, Company Y would have to pay a fixed rate of 12%, while after the swap, it would only have to pay the floating rate (LIBOR + 1.5%) to the swap bank, which is then swapped with a fixed payment of 9.9%.
So, Company Y saves 2.1% (12% - 9.9%) on $10,000,000, which equals $210,000 per year.
On the other hand, the swap bank pays interest at LIBOR - 0.15% to Company Y, which is then swapped with a fixed payment of 9.9%. 
This means the swap bank earns 0.75% (LIBOR - 0.15% - 9.9%) on $10,000,000, which equals $75,000 per year by taking on the interest rate risk. 
Therefore, Company Y saves $210,000 per year, while the swap bank earns $75,000 per year, resulting in net savings of $135,000 per year ($210,000 - $75,000). This equals 45 basis points on the notional amount of $10,000,000, so the correct answer is B.

Company X Wants to Borrow $10,000,000 Floating for 5 Years;