Swap

Dear Sir,

I have problem with part(b) of this question regarding the solution in BBP kit.

66 Sembilan Co (6/12, amended) 49 mins

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels.
This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years.
The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment
is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it
increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest
payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The
new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.
Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest
based on an equivalent fixed annual rate of 3.76¼% in exchange for receiving a variable amount based on the
current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus
Bank will charge an annual fee of 20 basis points if the swap is agreed and will also guarantee the swap. The current
annual spot yield curve rates are as follows:
Year One Two Three Four
Rate 2.5% 3.1% 3.5% 3.8%
The current annual forward rates for years two, three and four are as follows:
Year Two Three Four
Rate 3.7% 4.3% 4.7%

Required:-
(b) (i) Demonstrate that Sembilan Co’s interest payment liability does not change, after it has undertaken
the swap, whether the interest rates increase or decrease. (5 marks)