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Hi Sir,
Under the swap arrangement, it says in the question that the treasurer plans to borrow the funds at a variable rate of LIBOR plus 50 basis points. I automatically assumed that Lurgshall wants to borrow floating while the counterparty wants to borrow fixed. And therefore, in following your method from the lecture I analysed it this way:
Own borrowing:
Lurgshall – Libor + 0.5%
Counterparty – 6.1%
Total = Libor + 6.6%Swap borrowing:
Lurgshall – 5.6%
Counterparty – Libor + 1.5%
Total = Libor + 7.1%Therefore, it costs 0.5% more overall under the swap (excluding bank fees).
However, in the examiner’s answer Lurgshall wants to borrow fixed rate. And there is a saving for each party. Where in the question indicates this? Am I reading it incorrectly? I would hate not to understand in a question which party wants to borrow which rate in the exam.
Although I was initially tempted to think as you have done, it quickly becomes clear that a swap can only give a benefit if they do borrow floating but then swap and so end up paying fixed.
That made me re-examine the question and the problem is that although they are planning to borrow floating, they are expecting LIBOR to rise and are looking for ways of hedging against that. Using forward rates or futures would both effectively end up with them paying a fixed rate, and using options would provide a fixed limit. Similarly, entering into a swap will end with them paying a fixed rate, and it is then a question of providing advice as to which might be the most suitable method.
As a general rule, if you are not specifically told which way round the swap is required, then it would only ever be worthwhile considering in whichever way does end up giving a saving.
I hope that helps 🙂
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