Activity: Currency Exchange Risk Management Using Swaps Bob is asking for an explanation. He has left you a note on your desk. BOB'S NOTE: I'm still not entirely comfortable with the debt issuance and hedging using the futures. I'm also concerned because we've been offered a $20 million commercial loan priced using 3-month Libor index+100bp. My concern is that most of the company's assets are generating fixed-rate returns. I decided to explore a swap possibility. After some preliminary research, using a money center bank's swap trading desk and its traders' connections, a possible deal has started taking shape. Another company would be willing to pay our company a floating rate payment priced at 3-month Libor+25bp, while our company would have an obligation to pay a fixed rate of 5.55% annualized, with quarterly settlements. I'm not overly concerned with the other party's reasons for requiring these payments, so we don't have to calculate the other party's final cost. But we do need to remember that fixed-rate swap payments are made on a semiannual basis, based on 30/90/180/360 Accrual Year Fraction, while floating-rate side payments are being made on a quarterly basis, based on Actual/360 Accrual Year Fraction. I'd like you to calculate what would be the ultimate cost of the loan to our company. For the purpose of this assignment you may ignore the carrying costs and the brokerage fees of the swap arrangement. Deliverables The basis of the ultimate cost of the payment to the lender to our company.
Activity: Currency Exchange Risk Management Using Swaps
Bob is asking for an explanation. He has left you a note on your desk.
BOB'S NOTE:
I’m still not entirely comfortable with the debt issuance and hedging using the futures. I’m also concerned because we’ve been offered a $20 million commercial loan priced using 3-month Libor index+100bp. My concern is that most of the company’s assets are generating fixed-rate returns. I decided to explore a swap possibility.
After some preliminary research, using a money center bank’s swap trading desk and its traders’ connections, a possible deal has started taking shape. Another company would be willing to pay our company a floating rate payment priced at 3-month Libor+25bp, while our company would have an obligation to pay a fixed rate of 5.55% annualized, with quarterly settlements. I’m not overly concerned with the other party’s reasons for requiring these payments, so we don’t have to calculate the other party’s final cost. But we do need to remember that fixed-rate swap payments are made on a semiannual basis, based on 30/90/180/360 Accrual Year Fraction, while floating-rate side payments are being made on a quarterly basis, based on Actual/360 Accrual Year Fraction.
I’d like you to calculate what would be the ultimate cost of the loan to our company. For the purpose of this assignment you may ignore the carrying costs and the brokerage fees of the swap arrangement.
Deliverables
- The basis of the ultimate cost of the payment to the lender to our company.
TIPS FOR THIS ACTIVITY:
Please disregard all the steps except for this one
put together an algebraic expression for the cost of the lender. If your algebraic expression is correct, you will realize that no calculations of the actual Libor rate are needed
Example with the Prime rate: Prime+50 bp-3.75% +4% -Prime -20 = something like that, but, certainly with Libor.