Example on an interest rate swap

We have two companies A and B. A has an opportunity to raise funds at a lower price.
Both companies can select between a fixed interest and a floating interest loan.
The current offer rates for the two companies are:

Fixed Interest Rate

Floating Interest Rate

Company A
6.00%
Euribor + 1.00%

The current 6 month Euribor rate is

Company B
9.00%
Euribor + 2.00%

6.00%

A selects the fixed interest rate, B selects the floating rate.

The two companies have, however, different expectations on the future development of the 12 months Euribor:
Interest Rates faced by Com pany A

10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%

Interest Rates faced by Com pany B

11.00%
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%

Fixed Interest Rate

True Euribor + 1.00%
Exp. Euribor + 1.00%

Fixed Interest Rate

True Euribor + 2.00%
Floating Interest Rate

A and B can make a profit by the following interest rate SWAP agreement:
Fixed rate
6.00%

Company A

Euribor

Fixed rate 6.00%

Company B
Euribor + 2.00%

Outside Lender
(Bank)

Outside Lender
(Bank)

Comparing the net interest flows shows us that both companies can win in the arrangement
Floating interest for Company A
Fixed interest for Company B

Finance Market
Euribor + 1.00%
9.00%

SWAP
Euribor
8.00%

Company
Expected
6 A
month
Floating Interest
Helibor
Rate

ment of the 12 months Euribor:

ates faced by Com pany B

Fixed Interest Rate

True Euribor + 2.00%
Floating Interest Rate

pany B
Euribor + 2.00%

e Lender
ank)

rrangement

1.1.X1
1.7.X1
1.1.X2
1.7.X2
1.1.X3
1.7.X3
1.1.X4
1.7.X4
1.1.X5
1.7.X5
1.1.X6
1.7.X6
1.1.X7
1.7.X7
1.1.X8
1.7.X8
1.1.X9
1.7.X9

6.00%
6.50%
5.80%
4.70%
5.80%
7.80%
7.20%
5.40%
4.80%
4.50%
5.00%
6.20%
6.60%
6.90%
5.70%
5.30%
5.50%
5.90%

6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%

6.00%
5.00%
4.50%
5.00%
4.00%
3.80%
4.00%
3.90%
4.10%
3.80%
3.90%
4.00%
4.20%
4.00%
4.10%
3.80%
4.00%
4.20%

Exp. Euribor + 1.00%

Fixed
Interest
True 6 m
Rate

True Euribor + 1.00%

Market

True Euribor

Date

7.00%
7.50%
6.80%
5.70%
6.80%
8.80%
8.20%
6.40%
5.80%
5.50%
6.00%
7.20%
7.60%
7.90%
6.70%
6.30%
6.50%
6.90%

7.00%
6.00%
5.50%
6.00%
5.00%
4.80%
5.00%
4.90%
5.10%
4.80%
4.90%
5.00%
5.20%
5.00%
5.10%
4.80%
5.00%
5.20%

Fixed
Interest
Rate

9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%
9.00%

Compan

Exp. Euribor + 2.00%

6.00%
7.00%
7.50%
6.80%
7.20%
7.60%
8.00%
7.80%
8.40%
8.00%
8.20%
7.60%
8.00%
7.80%
8.20%
7.80%
7.70%
7.80%

True Euribor + 2.00%

Company
Expected
6 B
month
Floating Interest
Helibor
Rate

8.00%
8.50%
7.80%
6.70%
7.80%
9.80%
9.20%
7.40%
6.80%
6.50%
7.00%
8.20%
8.60%
8.90%
7.70%
7.30%
7.50%
7.90%

8.00%
9.00%
9.50%
8.80%
9.20%
9.60%
10.00%
9.80%
10.40%
10.00%
10.20%
9.60%
10.00%
9.80%
10.20%
9.80%
9.70%
9.80%

CASE 1:TESTING THE EXAMPLE

A and B have each taken the following bullet loan:
Bullet loan
Lump sum repayment period (years)
Interest payment period (months)

100000
5
6

Calculate the interest payment streams for A and B in the following cases (use the interest rates of example 1)
a) According to the preferred financing arrangement allowed by the market
b) A and B engage in the SWAP-agreement and their own expectations hold true
c) A and B engage in the SWAP-agreement under the true market conditions
d) Determine the break even level for the fixed rate.
e) Include a theoretical analysis of SWAPS based on Hull and a fresh international journal article.
Is the SWAP arrangement a good and central instrument for hedging in corporate finance?
What are the pitfalls and can they be avoided?
Financing costs before SWAP-agreement
Company A
Fixed Interest Rate
6.00%
Floating Interest Rate
Helibor + 1.00%
Financing costs after SWAP-agreement
Finance Market
Helibor + 1.00%
Floating interest for Company A
9.00%
Fixed interest for Company B

Company B
9.00%
Helibor + 2.00%

SWAP
Euribor
8.00%

e the interest rates of example 1)

ernational journal article.

n corporate finance?

HOW TO PRESENT THE SWAP-CASE !

COMPANY A
WITHOUT SWAP-AGREEMENT EURIBOR + 1 %
FIXED
INTERES TRUE INTEREST
EXPECTED
T RATE
RATE
INTEREST RATE
(6 %)
%
FIM
%
FIM

COMPANY A

CO

WITH SWAP-AGREEMENT EURIBOR

TRUE INTEREST
RATE
%

FIM

EXPECTED
INTEREST RATE
%

FIM

WITHOUT SWAP-AG
FIXED
INTERES
T RATE
(9 %)

COMPANY B

COMPANY B

WITHOUT SWAP-AGREEMENT EURIBOR + 2 %

WITH SWAP-AGREEMENT 8 %

TRUE INTEREST
RATE
%

FIM

EXPECTED
INTEREST RATE
%

FIM

TRUE INTEREST
RATE
%

FIM

EXPECTED
INTEREST RATE
%

FIM

CASE 2: CONSIDERING A SWAP IN THE FIRM MODEL

In your firm planning model, you have applied a fixed interest rate You can refine your analysis by assuming that
the new loan taken during the first or second planning year is a bullet loan to be repaid by the end of the planning
horizon and that this loan may be swapped. Interest is paid twice a year for the bullet loan.
Change your model to account for a variable yearly interest rate.
Would you be prepared to swap for a floating interest rate given the conditions stated below?
(1) You expect the yearly interest rate to change as follows:

floating rate:

year 5

year 6

year 7

year 8

fyear5 + 1%

fyear5

fyear5 - 1%

fyear5 - 1.5%

year 9
fyear5 - 1%

(2) You assume that your strategic decisions remain unaltered. Is the swap attractive?
(3) You want to adapt your strategy to the fluctuating interest rate expectations. Is the swap profitable now?

N THE FIRM MODEL

e your analysis by assuming that

repaid by the end of the planning

stated below?

Is the swap profitable now?