Companies X and Y have been offered the following rates per annum on a $5 million 10-year investment.Fixed rate Company X is 4% ；Floating rate Company X is BBSW；Fixed rate Company Y is 5% ；Floating rate Company Y is BBSW+2.5%. Company X requires a floating-rate investment. Company Y requires a fixed rate investment. Design a swap such that the dealer bank can receive a commission fee of 0.5% p.a., and the net gain is equally shared between the two companies. Please answer the following questions: (1) Identify the relative comparative advantages for each of the two companies. (2) Compute the net gains from the swap, and how much each company will receive. (3) Design the swap. You can either simply draw the swap plot or discuss the steps in words, to cover the following items. – What rates do each company invest at? – How do they exchange the interest payments with their counter-party? – What are their final investment returns?
Question
Companies X and Y have been offered the following rates per annum on a $5 million 10-year investment.Fixed rate Company X is 4% ；Floating rate Company X is BBSW；Fixed rate Company Y is 5% ；Floating rate Company Y is BBSW+2.5%. Company X requires a floating-rate investment. Company Y requires a fixed rate investment. Design a swap such that the dealer bank can receive a commission fee of 0.5% p.a., and the net gain is equally shared between the two companies. Please answer the following questions: (1) Identify the relative comparative advantages for each of the two companies. (2) Compute the net gains from the swap, and how much each company will receive. (3) Design the swap. You can either simply draw the swap plot or discuss the steps in words, to cover the following items. – What rates do each company invest at? – How do they exchange the interest payments with their counter-party? – What are their final investment returns?
Solution
(1) Comparative Advantages: Company X has a comparative advantage in borrowing at a fixed rate, as it can borrow at 4% compared to Company Y's 5%. On the other hand, Company Y has a comparative advantage in borrowing at a floating rate, as it can borrow at BBSW+2.5% compared to Company X's BBSW.
(2) Net Gains: The net gain from the swap would be the difference between the fixed rates (5% - 4% = 1%) and the difference between the floating rates (BBSW - BBSW+2.5% = -2.5%). This results in a net gain of -1.5%. However, the dealer bank will receive a commission fee of 0.5%, leaving a net gain of -2% to be shared between the two companies. As the net gain is equally shared, each company will receive -1%.
(3) Swap Design: Company X will invest at a fixed rate of 4% and Company Y will invest at a floating rate of BBSW+2.5%. They will then swap their interest payments, with Company X paying Company Y the 4% fixed rate and Company Y paying Company X the BBSW+2.5% floating rate.
After the swap, Company X's final investment return will be BBSW+2.5% - 4% = BBSW - 1.5% and Company Y's final investment return will be 4% - (BBSW+2.5%) = 1.5% - BBSW.
Please note that the final investment returns are subject to the actual BBSW rate. If the BBSW rate is higher than 1.5%, Company X will have a higher return and if the BBSW rate is lower than 1.5%, Company Y will have a higher return.
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