Question

Question 2 wo companies that differ in their credit ratings, Rigel Corp. and Vega Ltd, would like to borrow an amount of money. They have been quoted with the following rates: Rigel Corp: 6.5% fixed, or LIBOR + 0.5% Vega Ltd. 9.5% fixed, or LIBOR + 1.5% Vega Ltd. would like to borrow at a fixed interest rate, while Rigel Corp. would want to be under a variable interest rate scheme. Assume that a financial intermediary (e.g., a bank) suggests the two companies to enter into an interest rate swap with the financial intermediary for an annual fee of 120 basis points Answer the following questions: Why are financial managers using swaps and why have swaps become so popular today? 2.1 (496) 2.2 What is an interest rate swap? Describe in detail its characteristics. (4%) Based on the information regarding the two firms mentioned above (Rigel and Vega) answer the following questions: 2.3 What are the total savings for the companies when they participate in the swap net of (6%) Assume that the two companies would equally split the savings. In this case, what (6%) the fee? 2.4 would be the effective interest rate payable by the two companies? If the variable interest rate in the swap contract is equal to LIBOR, find the fixed interest rates paid/received by the two companies? 2.5 (13 %) TOTAL 33 %

Answer 1

Use of Interest Rate Swaps -

An interest rate swap is a financial derivative that companies use to exchange interest rate payments with each other. Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead.

Characteristics : http://www.iotafinance.com/en/Article-Interest-rate-swaps.html