Interest Rate Swap - A Treasurer's Dilemma

1. Three years ago, Euroco Limited, entered into a swap transaction following the raising of a 6-year $150 million syndicated facility to fund a major acquisition. The loan was priced at 3 months LIBOR plus 0.75%. The facility was immediately swapped. At that time Euroco obtained three quotes for a 6 year swap:
   
   Bank A : 10.77% - 10.72%
   Bank B : 10.75% - 10.72%
   Bank C : 10.76% - 10.73%
   
   (All quotes are on a quarterly basis vs 3 month LIBOR)
   
   a) Which was the best quote shown to the treasurer?
   b) What was then the effective funding cost for Euroco?
   
   
2. Today the treasurer is convinced that the rates are likely to fall further and therefore, and therefore he wants to revert to a floating interest rate by re-swapping. The treasurer calls three banks which give him the following quotes:
   
   Bank A : 6.92% - 6.98%
   Bank B : 6.93% - 6.90%
   Bank C : 6.95% - 6.90%
   
   a) Which was the best quote shown to the treasurer?
   b) What was then the effective funding cost for Euroco?
   b) Is the first swap in or out of the money for Euroco?
   
   
3. A year later, Euroco undergoes major downsizing resulting in the sale of the company purchased 4 years previously and the early repayment of the loan facility. The previous treasurer has left the company and you are the newly appointed treasurer. You have decided to close out the two swap transactions:
   
   a) Will the cancellation of the swaps result in a payment from Euroco to the bank or from the bank to
        Euroco?
   b) Current swap rates are now around 8% (quarterly basis). Using this as a discount rate, estimate the
        amount to be paid by one of the parties to the other (payments are made quarterly).
   c) In the light of the interest rate movements over the last 4 years, how would you evaluate your
        predecessor’s decisions?
   
   

   Solution:

   1. (a) Which quote ?

   1. Euroco entered a swap under which it will pay the fixed rate on the swap (swap coupon) and receive 3 month LIBOR. Euroco will choose the bank which allows it to pay the lowest coupon, i.e. 10.75% and that would be Bank B

      (b) Funding Cost?

      After the swap Euroco will receive 3 month LIBOR from the swap dealer (in this case Bank B) and pay to Bank B 10.75%. In addition it will have to pay 3 month LIBOR + 0.75% on the loan facility (to the lender). Therefore, Euroco’s net coupon pay-out (funding cost) C will be 11.50% as shown:

       

      C = LIBOR - 10.75% - (LIBOR + 0.75%)
      ⇒ C = -11.50%

      Euroco’s funding cost will be 11.50%. Note that this quote is a quarterly one with payments made quarterly and therefore the funding cost is a nominal rate and not an effective rate.
      

   2. (a) Unwinding the first swap:

      The treasurer will be receiver of fixed rate on the second swap. He will therefore seek to receive the highest rate on the bid side : 6.90%. The treasurer can choose between two banks, namely bank B and C. Given that the first swap was transacted with bank B, it would be much wiser to unwind with the same bank. In this case there would be a reduction in credit risk for the treasurer. Re-swapping with bank C (another bank) would have resulted in a doubling of a credit risk.

      (b) Cost of funds after re-swapping:

      After re-swapping, Euroco will pay 10.75% and receiving 6.90%, the three months LIBOR will cancel out between the two swaps. In other words, the two swaps will be a net cost for Euroco of 3.85%. After re-swapping Euroco’s net coupon pay-out (funding cost) C will be LIBOR plus 460 basis points as shown:

       

      C = LIBOR + 6.90% - (LIBOR + 0.75% + 10.75% + LIBOR)
      ⇒ C = -LIBOR - 4.60%

      (c) Swap In or Out of the Money?

      Clearly the unwinding of the swap results in a significant loss of Euroco. The swap is therefore deep out of the money for Euroco.

   3. (a) The closing out of the two swaps will represent a net cost to Euroco
            corresponding to the net present value of 3.85% on $150 million over
            the next two years.

      (b) The difference between the two rates should be paid by Euroco to the
            bank every quarter. The quarterly amount should be:

      $150,000 * 3.85% * (¼) = $1,443,750

           The total amount due by Euroco under the unwinding of the swap will
            be:

      $1,443,750*8 = $11,550,000

           This calculation, however, is misleading as it does not take into account
            the timing of the cash flows. To estimate this more accurately we need
            a discount rate and we can use the Excel? built in function PV
            to estimate the total amount.It turns out to be $10,576,164.

      (c) The decision to swap into fixed rate was wrong as the company could
            not take advantage of the falling interest rates. The second decision of
            reversing out of the first swap was also wrong since the treasurer's
            timing was bad as it seems that he reversed out of the initial swap when
            the rates were at their lowest, locking in greatest loss.

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