Explain how the conversion could be carried out by an interest rate swap
Phillip’s Screwdriver Company has borrowed $20 million from a bank at a floating interest rate of 2 percentage points above three-month Treasury bills, which now yield 5 percent. Assume that interest payments are made quarterly and that the entire principal of the loan is repaid after five years. Phillip’s wants to convert the bank loan to fixed-rate debt. It could have issued a fixed-rate five-year note at a yield to maturity of 9 percent. Such a note would now trade at par. The five-year Treasury note’s yield to maturity is 7 percent.
a. Is Phillip’s stupid to want long-term debt at an interest rate of 9 percent? It is borrowing from the bank at 7 percent.
b. Explain how the conversion could be carried out by an interest rate swap. What will be the initial terms of the swap? (Ignore transaction costs and the swap dealer’s profit.) One year from now medium- and long-term Treasury yields decrease to 6 percent, so the term structure then is flat. (The changes actually occur in month 5.) Phillip’s credit standing is unchanged; it can still borrow at 2 percentage points over Treasury rates.
c. What net swap payment will Phillip’s make or receive?
d. Suppose that Phillip’s now wants to cancel the swap. How much would it need to pay the swap dealer? Or would the dealer pay Phillip’s? Explain.
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