question archive Companies A and B wish to borrow £40 million for a period of 7 years
Companies A and B wish to borrow £40 million for a period of 7 years
Subject:FinancePrice:3.86 Bought15
Companies A and B wish to borrow £40 million for a period of 7 years. The following table summarises the interest rates of the deals offered to each company: Company Fixed Floating A 3.7% LIBOR+1% B 6.2% LIBOR+2% Company A would like to borrow at floating interest rate while company B would like to borrow at fixed rate. A financial institution has offered to design a swap deal and it charges 0.3% for that service. Answer the following questions: a. Explain the comparative advantage position for both companies. (5 marks) b. Explain how the swap deal would work if the comparative advantage is shared equally between both parties. (10 marks) c. Briefly describe how a Credit Default Swap works and its implications during the financial crisis. (10 marks)
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Given Information
|
Company |
Fixed Rate |
Floating Rate |
|
A |
3.7% |
LIBOR+1% |
|
B |
6.2% |
LIBOR+2% |
|
Comparative Advantage |
2.5% to Company A |
1% to Company A |
a.
Company A has comparative advantage in both Fixed as well as Floating borrowings but it has greater comparative advantage in Fixed borrowing.
So, Company A will borrow in Fixed and swap it with Company B and Company B will borrow in Floating and swap it with Company A.
b.
Total or combined interest savings = 2.5%-1% = 1.5%
Charge of Financial Institution = 0.3%
So, Net Saving = 1.5% - 0.3% = 1.2%
The saving of 1.2% is shared equally between A & B
So
- Company A will borrow in Fixed at 3.7% and pass it on to Financial Institution at 5.3% which in turn lends it further to Company B at 5.6%
- Company B will borrow in Floating at LIBOR+2% and pass it on to Financial Institution at LIBOR+2% which in turn lends it further to Company A at LIBOR+2%
Company A’s net borrowing rate = (LIBOR+2%)+3.7%-5.3% = LIBOR+0.4% (Saving of 0.6% from Floating rate of LIBOR+1%)
Company B’s net borrowing rate = 5.6%+(LIBOR+2%) - (LIBOR+2%) = 5.6% (Saving of 0.6% from Fixed rate of 6.2%)
Financial Institution = -5.3%+5.6%-(LIBOR+2%) +(LIBOR+2%) = 0.3% (Earning of 0.3%)
c.
A Credit Default Swap (CDS) is a type of insurance against the credit risk. Need for CDS arises from the requirement of a lender who wants to protect himself from any default by his borrower. In CDS, there are two parties, one is a buyer of protection and other is seller of protection. Same is depicted as under –
|
Party A |
Transaction |
Party B |
|
Buyer of Protection |
------------------à Buyer of protection makes periodic payments (premium) to seller of protection ß------------------- Seller of protection provides insurance to Buyer against credit default faced by the Buyer during protection period. In case of any default faced by Buyer, Seller pays to Buyer the amount equal to the shortfall in the recovery of its dues from the defaulter. At this point of time, the Buyer no longer needs to pay the premium to seller. If there is no default during the protection period, Buyer has to pay the premium till the end of the protection period. |
Seller of Protection |
CDS is said to be one of the main causes of financial crisis whereby CDS sellers like Lehman Brothers and AIG defaulted on their CDS obligations. Although CDS is said to be like insurance but one main difference is that in insurance, there is a requirement for insurable interest but in CDS, there is no such requirement. This led to great speculation in CDS market with CDS claims outstanding being many times higher than the value of the underlying. CDS works on the principle of distributing the credit risk over many participants. For e.g. taking premium from 100 participants to take care of the default faced by 1 or 2 participants. This system works well in normal and stable time but breaks down in time like financial crisis.
