Problem 1

Alpha and Beta Companies can borrow at the following rates.

Alpha Beta

Moody's credit rating Aa Baa

Fixed-rate borrowing cost 8 % 11 %

Floating-rate borrowing cost LIBOR+.25 LIBOR + 1.25%

Calculate the Quality Spread Differential (QSD)

The QSD = (11.0% - 8%) minus (LIBOR + 1.25 % - LIBOR+.25) = 2%.

Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.

Alpha needs to issue fixed-rate debt at 8% and Beta needs to issue floating rate-debt at LIBOR + 1.25%. Alpha needs to pay LIBOR+.25 to Beta. Beta needs to pay 9% to Alpha. If this is done, Alpha's floating-rate all-in-cost is: 8% + LIBOR+.25 - 9% = LIBOR - .75%, a .75% savings over issuing floating-rate debt on its own Beta's fixed-rate all-in-cost is LIBOR+ 1.25% + 9% - LIBOR = 10.25%, a .75% savings over issuing fixed-rate debt.

now assume that A SWAP BANK IS INVOLVED AS AN INTERMEDIARY AND THE OSD WILL BE DIVIDED AS FOLLOW: 10 % FOR SWAP BANK, 50 % FOR BETA AND 40% FOR ALPHA

The new QSD = (50.0% - 40%) minus (LIBOR + 1.25 % - LIBOR+.25) = 9%.

Alpha needs to issue fixed-rate debt at 40% and Beta needs to issue floating rate-debt at LIBOR + 1.25%. Alpha needs to pay LIBOR+.25 to Beta. Beta needs to pay 44.5% to Alpha. If this is done, Alpha's floating-rate all-in-cost is: 40% + LIBOR+.25