In an Interest-Rate Swap Transaction, a Large Corporation Can Borrow

Essay

In an interest-rate swap transaction, a large corporation can borrow in the bond market at a current fixed rate of 9 percent and can also obtain a floating-rate loan in the short-term market at the prime bank rate. However, this firm wishes to borrow short-term because it has a large block of assets that roll over into cash each month. The other party to the swap is a company with a lower credit rating that can borrow in the bond market at an interest rate of 11.5 percent and in the short-term market at prime plus 1.50 percent. This lower-rated company has long-term predictable cash inflows, however. The higher-credit-rated company wishes to pay for its part in the swap an interest rate of prime less 50 basis points. The lower-rated company is willing to pay the underwriting cost associated with the higher-rated company's security issue, which is estimated to be 25 basis points. The swap transaction is valued at $100 million. What kind of interest rate swap can be arranged here? Which company will borrow short term and which long term? If the prime bank rate is currently 10 percent, who will pay what interest cost to whom? Explain what the benefit is to each party in this swap.