Page 153 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 6. Callable Swaps: A callable swap gives the holder, i.e. the fixed-rate payer, the right to
terminate the swap at any time before its maturity.
7. Extendible Swaps: In an extendible swap, the fixed rate payer gets the right to extend the
swap maturity date.

Example: Consider two companies A and B. Company B has a higher credit rating than
company A and can, therefore, raise funds at lower costs in both the fixed rate and floating rate
debt markets. Company B, however, has a greater relative cost advantage over company A in
the fixed rate market than in the floating rate market (95 basis points versus 12.5 basis points). It
would, therefore, be mutually advantageous for company A to obtain floating rate funding and
for company B to obtain fixed rate funding and then to enter into a swap arrangement.
Company A wants to obtain medium term four years financing at a fixed rate. In case A were to
float fixed four year bonds, it would have to pay interest @11.70%. An alternative available to
the company is to get a term loan at LIBOR + 3/8%.
Company B, simultaneously, wants to borrow floating rate dollars. It can float fixed bonds
@10.75%. Alternatively, it could borrow 6 months floating rate dollars in the interbank market
1
at LIBOR + . Company B can borrow fixed rate dollars in the market at 95 basis point below
4.25
the rate that company A would have to pay. Company B has privileged access to fixed rate funds
vis-à-vis company A.
Company A Company B Differential
Fixed 11.70 % 10.75 % 95 Basis Points
Floating LIBOR+ 3/8 % LIBOR+ ¼ % 12.5 Basis Points

The two companies enter into a swap in the following manner:
A borrows floating rate funds at LIBOR +3/8 and sells it to B at LIBOR.
B borrows fixed rate money at 10.75% and sells it to A at 11.00%.
In this manner, both companies are able to raise funds in the market in which each desires.
A gains (.70 – 0.375) 32.5bp and B gains (0.25 + 0.25) 50 bp. The savings is more than what would
have been obtained had each company accessed the market directly. The combined savings
when both the firms grow simultaneously is 82.5 bp. Such an arrangement is beneficial to both
the parties concerned.
Company A which was in the market for fixed rate funds, is able to obtain the funds at 11 per cent
instead of 11.70 per cent. Company B which was seeking funds at a floating rate, is able to obtain
1
the funds at LIBOR instead of LIBOR + per cent.
4.25

Example: Firm A can issue US dollar denominated fixed rate debt at 9.5 per cent or
floating rate debt at LIBOR plus 15 basis points (bps). Firm B which is less credit worthy can issue
dollar denominated fixed rate debt of the same maturity at 10.4 per cent or floating rate debt at
LIBOR plus 35 bps.

Firm A Firm B Differential
Fixed 9.5% 10.4% 90bps
Floating LIBOR + 15 bps LIBOR + 35 bps 20 bps
70 bps

148 LOVELY PROFESSIONAL UNIVERSITY