Final answer:
The QSD is calculated by averaging the differences in spreads over the preferred index rates for companies A and B, then adjusting for the swap bank's fee. Each company saves 0.28125% from the swap, allowing them to pay less than without the swap, considering their preferred index rates.
Step-by-step explanation:
The student's question pertains to the determination of the Quarterly Savings Differential (QSD) and the setting up of a floating-for-floating interest rate swap between two companies with different credit ratings. Company A can issue Floating Rate Notes (FRNs) at six months LIBOR + 0.125%, but it prefers a three-month LIBOR + 0.125% due to its asset structure. Conversely, Company B can issue FRNs at six months LIBOR + 1.0% and prefers this option; however, it has the alternative of issuing at three-month LIBOR + 0.625%. With a notional principal of $15,000,000, we need to calculate the savings each company would receive through the swap and factor in the swap bank's fee of 0.125%.
Firstly, we calculate the differences in spreads for each company over their preferred index rates: Company B will be paying 0.875% more on the six-month LIBOR compared to Company A (1.0% - 0.125%), and Company A pays 0.5% less on the three-month LIBOR compared to Company B (0.625% - 0.125%). The QSD would be the average of these figures, which is (0.875% + 0.5%) / 2 = 0.6875%. After deducting the swap bank's fee of 0.125%, the remaining savings of 0.5625% would be equally shared between the two companies, effectively leading to a savings of 0.28125% each.
In the swap agreement, Company A would pay the three-month LIBOR + 0.40625% (0.125% + 0.28125%) and receive six-month LIBOR + 0.125%, while Company B would pay six-month LIBOR + 0.71875% (1.0% - 0.28125%) and receive three-month LIBOR + 0.125%. Each company is paying less than it would have without the swap after accounting for their respective preferences.