Int rate swap – mar/june 17 – Buryecs Co

If Buryecs (B) were to do its own borrowing then they would pay W + 0.6% and the counterparty (C) would be 5.8%. So a total of W + 6.4%

If instead the borrow the opposite , then B would be paying 4% and C would be paying W + 0.4%. So a total of W + 4.4%. Therefore there is a saving to be made before bank fees of 2%, of which B would get 1.2% and C would get 0.8%.

Therefore, compared with doing its own borrowing, B must end up paying a net W + 0.6% (the amount if they didn’t swap) less 1.2% (their share of the saving), so a net W – 0.6% (before bank fees).

How they achieve this final W – 0.6% is really up to the parties to agree, but the examiners suggestion is:

B borrows fixed and so is paying 4%
B pays W to C, and so is now paying a total of W + 4%

But B must end up paying a net W – 0.6%, and so to make it work, B must receive the difference of 4.6% from C.

So the net amount that B is paying is W + 4% – 4.6% = W – 0.6%

An equally valid alternative would be as follows:

B borrows fixed and so is paying 4%
B pays the interest on C’s borrowing and so is now paying 4% + W + 0.4% = W + 4.4%
B receives interest from C of 4% and so is now paying a net W + 0.4%
As above, B must end up paying a net W – 0.6%
So to settle up B would then receive from C 1%

Either would be fine, but always read the question carefully. In several questions it has been specifically written that as part of the swap Libor (in this case W) is paid to the counterpart, and in that case it has to be the settling up as in the examiners answer to this question.