Question

Company A is an AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month LIBOR +.135 percent or at three-month LIBOR + 135 percent. Given its asset structure, three-month LIBOR is the preferred index. Company B is an A-rated firm that also desires to issue five-year FRNs. It finds it can issue at six-month LIBOR +1.0 percent or at three-month LIBOR +.635 percent. Given its asset structure, six-month LIBOR is the preferred index. Assume a notional principal of $15,000,000. Determine the quality spread differential

Answer 1

The quality spread differential (QSD) between the preferred borrowing terms for Company A (AAA-rated) and Company B (A-rated) is 86.5 basis points, where basis points are one-hundredth of a percentage point.

Step-by-step explanation:

The question involves the concept of quality spread differential (QSD), which is a measure used in finance to compare the credit spreads of two different class securities, often indicating a risk premium for lower credit quality bonds.

Company A, which has an AAA rating, can issue floating rate notes (FRNs) at six-month LIBOR +.135 percent or at three-month LIBOR +.135 percent. Company B, with a lower A rating, has the option of issuing FRNs at six-month LIBOR +1.0 percent or at three-month LIBOR +.635 percent.

To calculate the QSD between Company A and Company B for the preferred index for each company, we subtract the spread for the higher-rated company from the spread for the lower-rated company for their chosen LIBOR indices.

For Company A's preferred three-month LIBOR the spread is .135 percent. For Company B's preferred six-month LIBOR the spread is 1.0 percent. Therefore, the QSD is:

1.0 percent (Company B six-month LIBOR spread) - .135 percent (Company A three-month LIBOR spread)= 0.865 percent or 86.5 basis points.