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Hi John,
Could you please help me to understand how does this swap work? I have no problem with swap fixed-for-floating, because one leg is variable component (e.g. LIBOR), and the other is balancing figure. I am however confused when both legs are fixed. Please see the example, I don’t know how to get to the exchange of 6.25% and 4.25% in the final part.
A is settled in the US and wants Euro debt.
F is settled in Eurozone and wants Dollar debt.
Bank can organize a swap for fee of 0.2 % to each party.Dollar%
A: 6.25%
F: 7.25%Euro%
A: 4.50%
F: 5.00%Estimate the gain or loss in % to both A and F.
Solution
Difference
Dollar% 6.25% – 7.25% –> 1.00%
Euro% 4.5% – 5.00% –> 0.5%Difference of differences=1.00%-0.50% = 0.50%
Gain of 0.5% is available. Net of fees = 0.5%-2*0.2%=0.1%. Split evenly, gives 0.05% gain per company.
Effective rate for A=4.5%-0.05%=4.45%
Effective rate for F=7.25%-0.05%=7.2%A
Loan 6.25%
Swap:
Fees 0.20%
Swap in dollars -6.25% <– not clear
Swap in euros 4.25% <– not clear
Total = 4.45%F
Loan 5.00%
Swap:
Fees 0.20%
Swap in dollars 6.25%
Swap in euros -4.25%
Total = 7.20%Many thanks in advance,
JustynaIf there was no swap and they did there own borrowing the required currency, then A would pay 4.5% and F would pay 7.25%.
We know that the swap will save them 0.05% each after fees, so A must end up paying 4.50 – 0.05 = 4.45% and F must end up paying 7.25 – 0.05 = 7.20%
The way they can achieve that is by borrowing in the other currency and swapping the interest payment.
That would end up meaning A paying 6.25% and F paying 5.00%The desired end result can be achieved in several ways subject to what they agree on (and usually exam questions only require the final outcome). However what the answer you are quoting has decided to do is as follows: F pays A 6.25%. So F is now paying 5.00 + 6.25% = 11.25%. They pay fees of 0.20% so F is now paying 11.45%. To end up with the desired result, of F paying 7.20% he needs to receive 11.45 – 7.20 = 4.25%.
As a result A ends up paying 6.25%, receiving 6.25% from F, paying 4.25% from F and paying fees of 0.20%. A net result of 4.45% which is what was required.
Dear sir,
and if we are asked just to calculate what would be the gain for the company under Swap arrangement – is it ok to show the first part of the above calculations without producing the table who pays whom what and what receives? This table is a bit time consuming and anyway we obtain the results in the first part of the calculation:
Difference
Dollar% 6.25% – 7.25% –> 1.00%
Euro% 4.5% – 5.00% –> 0.5%Difference of differences=1.00%-0.50% = 0.50%
Gain of 0.5% is available. Net of fees = 0.5%-2*0.2%=0.1%. Split evenly, gives 0.05% gain per company.
Effective rate for A=4.5%-0.05%=4.45%
Effective rate for F=7.25%-0.05%=7.2%Thank you.
Yes, that is perfectly acceptable. For most questions in the exam that is all that is asked for – the rest is only needed if you are specifically asked how they will ‘settle up’ between themselves 🙂
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