CXP and RTQ, two companies based in C-land where the currency is the C$, both need to borrow C$10 million for a period of a year. CXP would like to borrow on a fixed rate and RTQ on a floating rate.

CXP has a relatively poor credit rating and the best rates offered are fixed at 12% and floating rate of SONIA + 3%. RTQ can borrow fixed at 9% and floating at SONIA + 1%.

A swap is arranged between the two entities which provides a fixed rate to CXP and a floating rate for RTQ, with any benefits being shared equally Ignore transaction costs.

What is the net cost of borrowing for CXP as a result of the swap arrangement?

Solution

A.9.0%

B.10.5%

C.11.0%

D.11.5%

To determine the net cost of borrowing for CXP as a result of the swap arrangement, we need to compare the borrowing rates and the terms of the swap agreement. Here’s the step-by-step solution:

1. **Direct Borrowing Rates:**
   - CXP: Fixed at 12% or Floating at SONIA + 3%
   - RTQ: Fixed at 9% or Floating at SONIA + 1%

2. **Objective:**
   - CXP wants a fixed rate.
   - RTQ wants a floating rate.

3. **Swap Arrangement:**
   - CXP will borrow at the floating rate (SONIA + 3%).
   - RTQ will borrow at the fixed rate (9%).

4. **Benefit Calculation:**
   - CXP’s floating rate: SONIA + 3%
   - RTQ’s floating rate: SONIA + 1%
   - Difference in floating rates: 3% - 1% = 2%
   - Difference in fixed rates: 12% - 9% = 3%

   If both companies swap, they can split the benefit of the differential in borrowing costs. The total benefit to be shared is the difference between the fixed rates minus the difference between the floating rates: $3% - 2% = 1%$.

5. **Net Benefit:**
   - Each company shares half of the 1% benefit: $ \frac{1%}{2} = 0.5% $

6. **CXP’s Cost after Swap:**
   - CXP borrows at SONIA + 3% and pays this rate.
   - CXP receives SONIA from the swap and pays a fixed rate instead.
   - The effective rate for CXP will be their original floating rate plus the net cost after the swap.

   $ \text{CXP's effective cost} = \text{CXP's fixed rate} - \text{benefit} = 12% - 0.5% = 11.5% $

Therefore, the net cost of borrowing for CXP as a result of the swap arrangement is:

**D. 11.5%**

Would you like further details or have any other questions?

Here are five additional questions you might be interested in:
1. How do currency swaps work in international finance?
2. What are the risks associated with interest rate swaps?
3. How can a company hedge against interest rate fluctuations?
4. What are the key differences between fixed-rate and floating-rate loans?
5. How do credit ratings affect a company's borrowing costs?

**Tip:** When dealing with financial swaps, always consider the credit risk associated with the counterparties involved in the swap arrangement.

Learn how to calculate the net cost of borrowing using interest rate swaps with a detailed example. Understand the differences between fixed and floating rates, and how swap arrangements impact borrowing costs. Suitable for college-level finance and economics students.

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