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Hi John,
1. When it is not specified whether a company wants to borrow fixed or floating, what is the rule of thumb in determining the rates to swap? (not specified in Fitzharris Co)
2 The solution in Fitzharris Co states that swaps give a better outcome when the base rate increases by 0.4%.
– In the computational parts of the swaps question, there was only one calculation not relating to any base rate movement.
– I calculate the outcome to be the same when base rate moves either way. The base rate is effectively L
Can you please explain?
Thanks
1. It is clear from the question. Under ‘transaction to be hedged’ it only mentions borrowing at floating rates. That would leave them as risk and so they are considering a swap so as to end up paying fixed. It is only under the details for the swap that the other rates are mentioned.
If it is not immediately clear in the exam, then check the way the examiner does in his answer (looking at the differentials) or alternatively the way I show in my lecture (which I prefer).
If F borrows fixed and the other borrows floating then the total interest is base rate + 5.9%
If F borrows floating and the other borrows fixed then the total interest is base rate + 5.3%So the second is better and F will borrow floating and swap so as to end up paying fixed.
2. Swapping so as to end up paying fixed means they end up paying the same fixed rate whatever happens to the base rate. That is the whole point of them swapping. Whether that is better than using options depends on whether or not they exercise the options which in turn depends on what happens to the base rate.
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