Two firms, Astor Corporation and Beluga Fish Packing Inc., are seeking financing in the fixed rate and floating rate debt markets. Given the rates at which they can borrow in these markets and their preferences, they sense an opportunity to reduce their borrowing costs by entering into a swap agreement and have decided to contact a swap bank/dealer. Astor Corporation can borrow at a floating rate of LIBOR + 1% or at a fixed rate of 12%. Beluga Fish Packing Inc. can borrow at a floating rate of LIBOR + 2% or at a fixed rate of 15%. Assume that Astor prefers to borrow at a floating rate and Beluga prefers to borrow at a fixed rate. You are the swap bank. Compute the quality spread differential (QSD) or the cost savings opportunity in these rates that makes a swap contract attractive. Structure an interest rate swap agreement that benefits both parties equally, reducing their borrowing costs (versus what it would otherwise be) and allows you to receive a fee of 1%. Show separately how you arrive at the net borrowing costs of Astor Corporation and Beluga Fish Packing Inc.

 

• The Quality Spread Differential or the cost-saving is 3% due to the difference between the credit quality of Astor and Beluga. 
• As the bank is charging 1% fees and nothing is mentioned about the proportion of distribution so assuming that to be equal, the cost of swap to Astor and Beluga are  (LIBOR - 1%) and (15% - 1%) respectively. Therefore, the net cost of borrowing of Astor and Beluga will be (LIBOR%) and (15%) respectively.

Step-by-step explanation

Interest-rate swap: It is an agreement between two parties for exchanging a stream of interest rate payment for the other, over-time in a specific period.

For example: Suppose there are two parties, X and Y having opposite expectations towards the market. X expects that the market will rise in the future and Y expects that the market will fall. X will prefer borrowing at a fixed rate whereas Y at a floating rate. X and Y will enter into a swap agreement with a swap bank. X entering into a payer swap and Y into a receiver swap.

Fixed for floating Swaps: It is an agreement where two parties swap fixed interest rate cash flow and the floating rate cash flow for mitigating risk in an open position.

• A receiver of fixed interest rate will be a receiver swap and B is paying 15% fixed rate then he'll be a payer swap.

Flow-chart can help you to ascertain the current scenarios:

Astor can borrow either at LIBOR+1% or 12% fixed rate but he prefers to borrow at LIBOR +1% (because he expects that rates of interest will fall). Beluga can borrow either at LIBOR + 2% or 15% fixed rate but he prefers to borrow at a fixed rate of 15% (because he expects that the rate of interest may see a rise in the future)

Astor and Beluga's credibility's are different as the fixed-rate at which both can borrow are different (Astor at 12% and Beluga at 15%). Therefore, the bank is getting a 3% quality spread differential ( 15% - 12%) because the bank is receiving 15% from Beluga and giving 12% to Astor.

• The balance of 3% will be the profit of the bank and it is charging only 1% fees so the bank will collect only 1% and distribute the rest 2% to Astor and Beluga. As Astor is more credible than Beluga but nothing is mentioned about the proportion of profit distribution, so quality spread differential or cost-saving is distributed equally among Astor and Beluga. The cost of swap for Astor and Beluga will be (LIBOR - 1%) and (15% - 1%) respectively.

Therefore, the net cost of borrowing of Astor and Beluga will be (LIBOR - 1% + 1%) = LIBOR and (15% - 1%) = 14% respectively. 

Please see the attached file for the complete solution