A company's investments earn LIBOR minus 0.5%.

 

Table 1: Swap quotes made by the market maker (Percent per annum)

Maturity (vears) Bid Offer Swap Rate

2 2,5 2,58 2,565

3 2,97 3,00 2,985

4 3,15 3,39 3,170

5 3,29 3,30 3,280

7 3,40 3,44 3,420

10 3,48 3,52 3,500

 

Use Table 1 to explain how the company can use the quoted rates to correct the investments to

(a) Two-year fixed rate investment

(b) Seven—year fixed-rate investments.

(c) The company also borrowed money at 5J% for five years and wishes to convert this

borrowing to a floating-rate liability by making use of the swap quotes in table 1, explain

how this can be done.

The company is currently receiving a floating rate on its investments liked to LIBOR such that floating rate = LIBOR- 50bps 

The company can convert the floating rate of interest to a fixed rate by entering into a receive fixed pay flotaing swap. The company would convert a floating rate asset into a fixed rate one if it feels interest rates are heading lower. 

(a) In order to convert to a 2 year receive fixed swap, the company will have to hit the market maker's bid for 2 year. Therefore it would be able to receive 2.55% fixed in exchange for LIBOR. Its effective rate will therefore become 2.55 - 0.5 = 2.05% 

(b) In order to convert to a 7 year receive fixed swap, the company will have to hit the market maker's bid for 7 year. Therefore it would be able to receive 3.4% fixed in exchange for LIBOR. Its effective rate will therefore become 3.4 - 0.5 = 2.90% 

(c) In order to convert the fixed rate liability into a floating rate liability, the company would have to enter into a receive fixed pay floating swap for 5 year. The company would be able to do so at the market marker's bid i.e. 3.26%. The company would therefore receive 3.26% fixed and pay a floating rate linked to LIBOR 

The effective cost of borrowing for the firm would therefore be: (5.1-3.26)% + LIBOR = LIBOR + 1.84% 

The company would do so if it feels that the interest rates are going to head lower