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tdill · Mar 20, 2012, 12:47 PM

Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%.

Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A.

What are the resulting net payments of A and B?

ArcSine · Mar 22, 2012, 03:59 AM

Each of the two counterparties has three distinct cash flow components to account for: (1) its payment on its own direct debt issue obligation; (2) its payment to the other counterparty under the swap deal; and (3) what it receives from the other counterparty under the swap. Two outflows and one inflow for each counterparty.

Write out A's three components, and net the inflow rate against the two outflow rates to get A's net rate. Ditto for B.

Hint: your answer for A will be some fixed rate, whereas B's answer will be in the form of a spread over libor. Therein, of course, lies the fundamental rationale for executing a swap like this. A issued floating-rate paper into the debt market, yet after application of the swap, ends up with an effective fixed rate; vice-versa for B.