sembilan co jun12

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.
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:
(a) Explain
why the fixed annual rate of interest of 3.76¼% is less than the four?year yield
curve rate of 3.8%.

Please tell this explanation as I didn’t get it from kaplan exam kit.