Interest rate swap June 2014 Q1 & June 2011 Q2c

In the June 2014 exam, CMC can borrow at a fixed 2.2% or a floating Y + 0.4%

The way a swap works is that they find a counterparty (CP) who borrow ‘the opposite’ of them (i.e. if CMC borrows floating then the CP borrows fixed, and vice versa). The CP in this question can borrow fixed at 3.8% or floating at Y + 0.8%.

So….if CMC were to borrow floating and the CP were to borrow fixed, then in total they will be paying Y + 0.4% + 3.8% = Y + 4.2%

On the other hand, if CMC were to borrow fixed and CP were to borrow floating, then in the total they will be paying 2.2% + Y + 0.8% = Y + 3%

So……between them they would save 1.2% – i.e. 0.6% each. They would both have to pay 0.2% in fees but they would still end up making a saving of 0.4% each.

They will only get this saving by borrowing and effectively paying each others interest.

So….if CMC had borrowing floating themselves they would have to pay L + 0.4%. Swapping will save 0.4% and they will end up paying only L
If CP had borrowed fixed themselves they would have to pay 3.8%. Swapping will save them 0.4% and they will end up paying only 3.4%.

The way they will actually achieve this end result is as follows (although this final bit was not required in the exam):

CMC will borrow fixed and pay 2.2%.
They will pay the fee of 0.2% to the bank.
They will pay L to CP and CP will pay 2.4% to CMC (this is the swap bit).
Net result means they end up paying 2.2% + 0.2% + L – 2.4% = L

CP will borrow floating at pay L + 0.8%
They will pay the fee of 0.2% to the bank,
They will pay 2.4% to CMC and receive L from CMC (this again is the swap bit).
Net result means they end up paying L + 0.8% + 0.2% + 2.4% – L = 3.4%

I hope that helps a bit!

(The fact that it was asked in June does actually make it unlikely that it will be asked again in December.)

You are welcome 🙂

(and you are right to leave no stone unturned 🙂 )

1 Correct 🙂

2 You can’t decide on one alone. You need to add together one party borrowing fixed and the other floating; and add together if they both borrowed the opposite to that. If the total is lower then there is a saving to be made that they can then share.

You are welcome 🙂

You should watch my lecture where I work through this question in full.

You can find it linked from this page:
https://opentuition.com/acca/afm/afm-revision-lectures/