Company CCC3, a low-rated firm, desires a floating-rate, long-term loan. CCC3 presently has access to floating interest
Question:
Company CCC3, a low-rated firm, desires a floating-rate, long-term loan. CCC3 presently has access to floating interest rate funds at a margin of 6.5% over LIBOR. Its direct borrowing cost is 14% in the fixed-rate bond market. In contrast, company AAA1, which prefers a fixed-rate loan, has access to fixed-rate funds in the Eurodollar bond market at 12% and floating-rate funds at LIBOR + 3.5%. A financial institution has brought these two firms together and facilitated the swap by taking the counterparty risk and requires a net total compensation package of 0.4% (this does not mean 0.4% from each, it means 0.4% total). (a) What is the size of the mispricing (if any)? (b) Design a swap acceptable to both companies and the financial institution. Split the benefits evenly between the two companies. Diagram the cash flows of the two companies and the financial institution. Clearly indicate the swap rates that the two companies and the institution are using. (c) What is the final borrowing rate for each company?