Company X,a low-rated firm,desires a fixed-rate,long-term loan.X presently has access to floating interest rate funds at a margin of 1.25% over LIBOR.Its direct borrowing cost is 11% in the fixed-rate bond market.In contrast,company Y,which prefers a floating-rate loan,has access to fixed-rate funds in the Eurodollar bond market at 9% and floating-rate funds at LIBOR + 1/4%.Suppose they split the cost savings.
-How much would X pay for its fixed-rate funds?
A)9.5%
B)10.0%
C)10.5%
D)10.75%

Question

Quizplus · Accepted Answer

Company X and Y can engage in an interest rate swap to benefit from their comparative advantages. The total cost savings from the swap is 1% (11% - 9% = 2% for fixed, and LIBOR + 1.25% - LIBOR - 0.25% = 1% for floating, total 3% savings). If they split the savings equally, each saves 0.5%. Therefore, X's effective fixed rate would be 11% - 0.5% = 10.5%.

Company X,a Low-Rated Firm,desires a Fixed-Rate,long-Term Loan