ARNBROOK PLC (JUNE 06 ADAPTED)

If Armbrook borrows fixed and the other borrows floating, then the total interest is 6.25 + L + 1.25 = L + 7.5%

If Arnbrook borrows floating and the other borrows fixed, then the total interest is 7.25 + L + 0.75 = L + 8.0%

Therefore there is a saving to be made of the difference of 0.5%

The answer does not say that Arnbrook will borrow at floating rate. It says that Arnrook will pay floating rate as a result of the swap.

Have you watched my free lectures on swaps???

If Armbrook does their own borrowing at floating rate then they will pay L + 0.75%

Swapping gives a total saving of 0.5% and if Arnbrook gets 60% of the saving (i.e. 0.3%) then they will end up paying L + 0.45% plus fees of 0.24% (120,000/50,000,000), so a total of L + 0.69%. The swap is worthwhile to Armbrook because the saving of 0.3% is more than the fees of 0.24%.

(However, the counterparty would end up paying 7.25% – (40% x 0.5%) + 0.24% = 7.29%. So because the saving to them is less than the fees, they would end up paying more after swapping and would not agree to the swap.)

Again, have you watched my free lectures on swaps?

i think the figures are slightly different in our books. Anyway, this is the question:

Arnbrook plc is considering a £50 million three?year interest rate swap. The company
wishes to expand and to have use of floating rate funds, but because of its AA credit rating
has a comparative advantage over lower?rated companies when borrowing in the domestic
fixed?rate market. Arnbrook can borrow fixed rate at 6.25% or floating rate at LIBOR plus
0.75%.
LIBOR is currently 5.25%, but parliamentary elections are due in six months’ time and future
interest rates are uncertain. A swap could be arranged using a bank as an intermediary. The
bank would offset the swap risk with a counterparty BBB?rated company that could borrow
fixed rate at 7.25% and floating rate at LIBOR plus 1.25%. The bank would charge a fee of
£90,000 per year to each party in the swap. Arnbrook would require 60% of any arbitrage
savings (before the payment of fees) from the swap because of its higher credit rating

My question is,
If they dont swap, they will have to pay the fixed rate of 6.25%
But if they do swap, they will pay:
1)L+0.75= 6
2) Bank charge (90,000/50,000,000)= 0.18
3) Savings of 0.3= (0.3)

Total= 6+0.18-0.3= 5.88%

Therefore, it is beneficial to Arnbrook to swap.

Is this correct?

Question- Evaluate whether or not the proposed swap might be beneficial to all parties.

Solution:

Fixed rate Floating rate
Arnbrook 6.25% LIBOR + 0.75%
BBB company 7.25% LIBOR + 1.25%

Difference 1.00% 0.50%

There is a potential 0.50% arbitrage saving from undertaking the swap.
On a £50 million swap this is £250,000 per year.
Arnbrook would require 60% of any saving, or £150,000 annually. The BBB company
would receive £100,000 annually.
The bank would charge each party £90,000 per year. This would leave a net saving of
only £10,000 for the BBB?rated counterparty company.
The swap is potentially beneficial to all parties, but the counterparty company might
press for a larger saving than £10,000

I personally found this explanation very confusing. Especially, the savings part. They have taken 50% of the savings and then 60% of it.

But i am relieved my solution showed in the previous reply is correct.

It does seem that they have muddled up the question (and answer) a bit. I do not understand why they have changed it from the original exam question!