The Star Chemical Company wants to finance an expansion of one of its production plants by borrowing $150 million for five years. Based on its moderate credit ratings, Star can borrow five-year funds at a 10.5% fixed rate or at a floating rate equal to the LIBOR + 75 bp. Given the choice of financing, Star prefers the fixed-rate loan. The Moon Development Company is also looking for five-year funding to finance its proposed $150 million office park development.

Given its high credit rating, suppose Moon can borrow the funds for five years at a fixed rate of 9.5% or at a floating rate equal to the LIBOR + 25 bp. Given the choice, Moon prefers a floating-rate loan. In summary, Star and Moon have the following fixed- and floating-rate loan alternatives:

Questions:

a. Describe Moon’s absolute advantage and each company’s comparative advantage.

b. What is the total possible interest rate reduction gain for both parties if both parties were to create synthetic positions with a swap?

c. Explain how a swap bank could arrange a five-year, 9.5%/LIBOR a swap that would benefit both the Star and Moon companies. What is the total interest rate reduction gain and how is it split?

Transcribed Image Text:

Company Fixed Rate Floating Rate Star Company 10.5% LIBOR + 75 bp Moon Company 9.5% LIBOR + 25 bp