Hewlett Packard (HP) and IBM both would like to borrow $750,000,000 for a 5-year period from the Eurodollar loan market in order to finance capital expenditures as the outlook for the US economy improves. HP prefers to borrow at a fixed rate and has a BBB+ rating. IBM prefers to borrow at a floating rate and has a AA- rating. HP and IBM can borrow for a 5-year term in the public debt markets at the following rates:

                             HP                                IBM

Fixed rate            3.5%                           2.5%

Floating rate     LIBOR + 1%         LIBOR + 0.5%

a. You are a swap bank (dealer) and would like to advice HP and IBM about potential savings from entering into an interest rate swap agreement. What is the total potential savings in borrowing costs that is possible from a swap deal?

b. Structure an interest rate swap that would provide HP and IBM equal cost savings in borrowing costs and allows you to pick up a fee of 0.1%.

c. As the swap bank, what fixed rate bid-ask spread would you quote for LIBOR, for this transaction?

d. What would be your annual dollar compensation, based on this bid-ask spread, for putting the transaction together and for assuming credit risk?

Answer rating: 100% (QA)

SOLUTION a To calculate the potential savings in borrowing costs from an interest rate swap agreement we need to compare the fixed rate borrowing costs of HP and the floating rate borrowing costs of IBM For HP Fixed rate 3 5 For IBM Floating rate LIBOR 0 5 Assuming LIBOR is currently at 2 we can calculate the potential savings for HP by comparing its fixed rate borrowing cost View the full answer