The 3 year USD bond issued by Company A has coupon of 11.5%, which the company thinks is too high. In fact the bond price has since risen substantially and current yield is 9.5%. The company thinks due to recent successful fund raising, interest rate will fall. Hence it wants to do interest rate swaps to change the payment from fixed rate to floating rate. Assuming that a bank is willing to do the trade up to USD notional of 1 million USD, it needs to consider the following facts to quote a price. Please give your best estimate, and rationale. 1. With the current 3 year USD swap rate of 1.4%, and bank receives the 11.5% coupon (payment is every 6 months, what is the Company’s credit risk premium? 2. If the Bank pays the Company 11.5% fixed rate to cover the coupon payment, what is the fair price the Company needs to pay the bank (assuming that the floating rate index is the 6 month Libor rate, currently at 1.72%)? 3. Please consider the credit risk premium the bank need to charge Company A in case the economy in the next 3 years does not favor the Company’s business. Please write down your arguments for your quote to the Company of the swap premium (6 month Libor rate + premium is what the Company needs to pay to the Bank)

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter8: Analysis Of Risk And Return

Section: Chapter Questions

Problem 10P

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The 3 year USD bond issued by Company A has coupon of 11.5%, which the company thinks is too high. In fact the bond price has since risen substantially and current yield is 9.5%. The company thinks due to recent successful fund raising, interest rate will fall. Hence it wants to do interest rate swaps to change the payment from fixed rate to floating rate.

Assuming that a bank is willing to do the trade up to USD notional of 1 million USD, it needs to consider the following facts to quote a price. Please give your best estimate, and rationale.

1. With the current 3 year USD swap rate of 1.4%, and bank receives the 11.5% coupon (payment is every 6 months, what is the Company’s credit risk premium?

2. If the Bank pays the Company 11.5% fixed rate to cover the coupon payment, what is the fair price the Company needs to pay the bank (assuming that the floating rate index is the 6 month Libor rate, currently at 1.72%)?

3. Please consider the credit risk premium the bank need to charge Company A in case the economy in the next 3 years does not favor the Company’s business. Please write down your arguments for your quote to the Company of the swap premium (6 month Libor rate + premium is what the Company needs to pay to the Bank)

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