Question

a company xyz corp., is seeking fixed rate funding for 5 years. it can borrow fixed with a bond issue at an effective cost of 9.25% or floating at a spread of 15 b.p. over 6-month libor. fixed to floating swaps are trading at libor versus fixed at 20 b.p. over 5 years treasuries. the yield on 5-year treasuries is 8.65%. show how xyz corp., can reduce its funding cost via an interest rate swap. what is the source of the gain to xyz?

Answer 1

XYZ Corp. can use an interest rate swap to effectively lock in a fixed rate of 8.85%, which is lower than the 9.25% fixed rate available directly. The saving of 40 basis points (0.40%) on its financing cost is the source of gain for XYZ.

Step-by-step explanation:

XYZ Corp. is seeking fixed rate funding for 5 years and can either borrow at a fixed rate of 9.25% or at a floating rate of 15 basis points over 6-month LIBOR. Fixed-to-floating interest rate swaps are trading at LIBOR versus fixed at 20 basis points over the 5-year Treasuries, which are at 8.65%. By entering into an interest rate swap, XYZ Corp. can synthetically create a fixed rate that is lower than 9.25%.

To reduce its funding costs, XYZ Corp. can borrow at the floating rate and simultaneously enter into a swap to pay fixed and receive floating. The swap's fixed rate would be the 5-year Treasury rate plus 20 basis points, which is 8.85% (8.65% + 0.20%). Therefore, the company would pay 8.85% fixed in the swap and receive 6-month LIBOR, which offsets the floating rate it pays on its debt. The net effect is that XYZ Corp. effectively locks in a fixed rate of 8.85%, which is lower than the original 9.25% it could borrow at.

The source of the gain to XYZ is the difference between the fixed borrowing rate it can get via the bond issue (9.25%) and the fixed rate it can effectively lock in via the swap (8.85%). This is a saving of 40 basis points, or 0.40%, on its cost of financing.