(a) Prawn and Lobster are two companies that can borrow for a five year term at the...
Question:
(a) Prawn and Lobster are two companies that can borrow for a five year term at the following rates.
Prawn | Lobster | |
International credit rating | A | B |
Fixed-rate borrowing cost | 6.5% | 10.5% |
Floating-rate borrowing cost | LIBOR + 1% | LIBOR + 3% |
(i) Calculate the quality spread differential (QSD).
(ii) Develop an interest-rate swap in which both Prawn and Lobster have an equal cost savings in their borrowing costs. Assume that Prawn desires floating-rate debt and Lobster desires fixed-rate debt. No swap bank is involved in the transaction. Assume that the payments are all made against flat Libor. Assume that Libor is currently 4%.
Fill in the blanks. Enter answers as one of the following formats. Numbers should be percentages to 2 decimal places, e.g. 1.23, LIBOR, LIBOR + 1.23
Prawn would borrow at a rate of Answer % from their bank.
Lobster would borrow at a rate of Answer % from their bank.
Prawn will pay AnswerLIBOR6.5% to Lobster.
Lobster will pay Answer6.5%LIBOR to Prawn.
Prawn's all in cost is Answer %
Lobster's all in cost is Answer %
(iii) Based on the information above suppose a swap bank is offering the following quote on USD Libor 7.1 – 7.2
Under this scenario Prawn will pay AnswerLIBOR7.1%7.2% to the swap bank and Lobster will pay AnswerLIBOR7.1%7.2%.
Based on this calculate the gain (in basis points) for:
Swap Bank - Answer bps
Prawn - Answer bps
Lobster - Answer bps
(b) The current spot exchange rate is EUR1.45 / USD 1.00, and the one year forward exchange rate is EUR1.4163 / USD 1.00. The one-year interest rate is 5% in euros and 4.5% in US dollars. You can borrow USD 4,000,000, or the equivalent EUR amount today, at the current spot exchange rate.
(i) Show how you can make a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Round all figures to the nearest number.
(ii) Calculate the size of the arbitrage profit.
Statistics for the Life Sciences
ISBN: 978-0321989581
5th edition
Authors: Myra Samuels, Jeffrey Witmer, Andrew Schaffner