Page 183 - Microsoft Word - 00 CIMA F1 Prelims STUDENT 2018.docx

Interest Rate Risk management

Example 5

Company A has recently set up and would like to take out a variable rate loan
for a new project. Company B also has a new project but would like to take out
a fixed rate loan in order to have certainty over interest payments.

Company A has been quoted a fixed rate of 10% and a variable rate of LIBOR
+ 5%. Company B, is well established and has been quoted a fixed rate of 8%
and a variable rate of LIBOR + 2.5%.

If they enter into a swap arrangement, agreeing to split gains equally,
what effective rate will each end up paying?

Solution

Preference: L+5% + 8% = L + 13%

Opposite: 10 + L + 2.5% = L + 12.5%

Difference = 0.5%, i.e. 0.5% saving if they swap. Split equally is 0.25% each.

A = L + 5% - 0.25% = L + 4.75%; B = 8% - 0.25% = 7.75%

Or
There is a bigger difference in the variable rates so to take advantage of
this, B will borrow variable and A then has to borrow at a fixed rate.

Use L% to get B on fixed and A on variable. Then 5.25% is the balancing
figure to split the saving on an equal basis.

It would work out like:

Co A Co B

Paid to bank (10%) (L+2.5%)

A pays B (L) L

B pays A 5.25% (5.25%)

––––– –––––

Net effect (L + 4.75%) (7.75%)

173