Finance and Accounting
Company A wants to borrow £25m for three years and is offered a variable rate loan commencing on 1st April 2014 at an interest rate of LIBOR + 3%, with interest re-set every six months. The company is particularly risk averse and would prefer a fixed rate loan and has a return requirement is 9% per annum.
Company B believes that interest rates are likely to remain stable over the period and is happy to pay floating rate interest in exchange for receiving fixed rate payments.
Assume that Company A and Company B arrange a derivative to be transacted on the 1st April 2014 so that Company A pays fixed interest over the period and Company B pays floating rate interest over the period. Assume that the fixed interest rate agreed for the it is LIBOR + 7% (fixed at inception), that LIBOR is 0.5% on 1st April 2014 and that on 30 June 2014 the LIBOR rate rises from 0.5% to 1%.
a) Describe the derivative trade that would enable such an exchange, the reasons why each company might want to transact such a derivative and calculate what the swap rate would be for Company A at inception. (choose a derivative)
b) How might Company B hedge its exposure to the interest rate rises and how might it fund that protection. You are required to show the impact of the strategy proposed using both a table and a graph.
c) What would the value of this derivative be on 02 September 2014 for Company A (using the Principal method)? Show how you reached your valuation using a cashflow analysis.
d) What risks are mitigated by this trade and what would you assess are the risks that this transaction represents for both Company A and Company B?
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