Company X and Company Y have been offered the following rates
Fixed Rate Floating Rate
Company X 3.5% 3-month LIBOR plus 10bp
Company Y 4.5% 3-month LIBOR plus 30 bp
Suppose that Company X borrows fixed and company Y borrows floating. If they enter into a swap with each other where the apparent benefits are shared equally, what is company X's effective borrowing rate?
A. 3-month LIBOR?30bp
B. 3.1%
C. 3-month LIBOR?10bp
D. 3.3%
A
The interest rate differential between the fixed rates is 100 basis points. The interest rate differential between the floating rates is 20 basis points. The difference between the interest rates differentials is 100 – 20 = 80 basis points. This is the total apparent gain from the swap to the two sides. Since the benefits are shared equally company X should be able to borrow at 40 bp less than it is currently offered in the floating rate market, i.e., at LIBOR minus 30 bp.
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