Let’s assume Vukile Property Fund Limited wants to borrow at floating rate and Oryx Properties Limited wants to borrow at fixed rate of interest. The two companies have been offered the following rates: Company Name Fixed Rate Floating Rate Vukile Property Fund Limited 7% 12 Months LIBOR+2% Oryx Properties Limited 9.5% 12 Months LIBOR+3.5% The gain from the swap will be equally distributed to the two companies. First National Bank agrees to facilitate the swap for a fee of 25 basis points. What swap can be designed? What is the benefit for each company? What are swaps and how can they be used practically by a Portfolio Manager? Total Marks of Q5: 20

Answer:

Interest rate swap is contract between two parties where a series of cash flow is exchanged on pre agreed principal amount. (E.g floating Vs Fixed)

Here we call Vukile Property Fund Limited as VPFL and Oryx Properties Limited as OPL.

Now here VPFL is able to borrow at 7% in fixed rate and at LIBOR + 2% in floating rate and here VPFL wants to borrow in floating rate.

And OPL is able to borrow at 9.5% in fixed rate and at LIBOR + 3.5% in floating rate and here OPL wants to borrow in fixed rate.

And here bank will charge 0.25% as fee for the swap.

1% = 100 basis points

Now here VPFL is has advantage in borrowing rates but OPL has some comparative advantage because in fixed rate the difference is ( 9.5% - 7%) = 2.5% and in floating rate (LIBOR + 3.5% - LIBOR - 2%) = 1.5%. In floating rate the difference is lower for OPL.

So here net advantage both parties can take is,

= 9.5% - 7% - [(LIBOR + 3.5%) - ( LIBOR + 2%)]

= 1%

So here 1% is net advantage is available.

But from this 0.25% will go to the bank for swap fee.

Now net advantage is 0.75% which will equally distributed,

So the borrowing rate for both parties will reduce by 0.75% /2 = 0.375%

Now Swap design:

Here we will say to VPFL to borrow in fixed rate from market and OPL to borrow in Floating rate.

And then we say VPFL to give LIBOR + 3.5% to the bank and bank will give this to OPL LIBOR + 3.375% after deducting swap charge of 0.125%.

And OPL will give 9% to the bank and bank will give this to VPFL 8.875% after deducting swap charge of 0.125%.

So here net cost of borrowing for both the Company is,

For VPFL,

= 7% (Pay interest for market borrowing) + LIBOR +3.5% (Pay under swap contract) - 8.875% (Receives under swap)

= LIBOR + 1.625%

So here our objective is achieved VPFL get loan at floating rate and at lesser cost of interest of 0.375%.

For OPL,

= LIBOR + 3.5% (pay interest for market borrowing) + 9% (under swap contract) - [LIBOR + 3.375%] (receives under swap)

= 9.125%

So here our objective is achieved OPL get loan at fixed rate and at lesser cost of interest of 0.375%.

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