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Sir could you please give me solution of part d as per your lecture. I went through yoyr lecture on interest rate swap,but i am not able to set it up. I could get the net saving of 1 after deducting fees,but please show me how to set it up as per lecture. Thanks
I am sorry, but this question does not have a part (d) (and does not ask anywhere about an interest rate swap).
hi sir
i have the same problem regarding interst rate swap please expalin.Q.Alaska Salvage is in discussion with potential lenders about financing an ambitious five-year project searching for
lost gold in the central Atlantic. The company has had great success in the past with its various salvage operations
and is now quoted on the London Alternative Investment Market The company is currently financed by 120,000
equity shares trading at $85 per share. It needs to borrow $1.6 million and wants to borrow at a fixed rate. Alaska
Salvage is concerned about the level of the fixed rates being suggested by the lenders, which are typically 9%. After
lengthy discussions the lenders are prepared to offer finance against a mezzanine issue of fixed rate five-year notes
with warrants attached. Each $10,000 note, repayable at par, would carry a warrant for 100 equity shares at an
exercise price of $90 per share. The estimated volatility of the returns on the company’s equity is 20% and the risk
free rate of interest is 5%.
You may assume that the issue of these loan notes will not influence the current value of the firm’s equity. The
issue will be made at par. The company does not pay dividends to its equity investors.
Alternatively Alaska Salvage is interested in an interest rate swap and has found a willing counterparty, which can
borrow at a variable rate of LlBOR + 2% or a fixed rate of 6.5%. The counterparty wants to borrow at a variable rate.
Alaska Salvage could borrow at a variable rate of LlBOR + 3%. Bank fees for the swap would be 0.25% each.
Illustrate how the interest swap could be structured to leave both parties better off than before the swap.
PS. sorry for long post but this is really irritating the way bpp has given solution
Thank youI will call Alaska A and the counterparty C, and I will ignore the bank charges because they just come off at the end and are easy to deal with.
If A borrows fixed themselves they will pay 9%, and if C borrows floating themselves they will pay L + 2%. So in total they will be paying L + 11%
If the have a swap, then A will pay L + 3% and C will pay 6.5% , so in total L + 9.5%.
So a saving to be made by swapping of 1.5% (or 0.75% each if they agree to share it equally.).
This is probably as far as the examiner will expect you to do (subject to then taking off the bank charges).
Just to be safe, as to how they actually sort it out, there are several ways, but the best is as follows.
The end result must be that A ends up paying fixed and C ends up paying floating, and that they both save 0.75% from what they would have paid if they had borrowed themselves without swapping.
So A must end up paying 9% – 0.75% = 8.25%.
and C must end up paying L + 2% – 0.75% = L + 1.25%However at the moment (because the borrowed the opposite of what they actually wanted) C is paying 6.5%. But they want it to be floating, so they will pay L to A. That means that they will then be paying L + 6.5%. But the must end up only paying L + 1.25%. So…..they must receive the difference of 5.25% from A.
Let’s now check A. Having arranged the swap they are paying L + 3%. However they are going to receive L from C, so that leaved them paying just 3%. Also, they are having to pay 5.25% to C, which means the total they end up paying is 8.25% (which is what we want to achieve 🙂 )
Hope that helps.
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