A firm has issued a debt of $5 million nominal amount maturing in 2 years and is referenced to the 3-month LIBOR. The firm wants to lock in the floating rate of its debt. To that end, it enters a subsidized swap constructed as follows:
First, it enters a vanilla 3-month LIBOR swap with an equivalent nominal amount ($5 million), in which it pays 4.5% fixed rate and receives the 3-month LIBOR. Second, it sells a 2-year cap with a $5 million nominal amount, referenced to the 3-month LIBOR. The strike price of the cap is set at 5.5%. The cap premium, equal to 0.2% of the nominal amount, is paid quarterly.
The financing cost for the firm can be calculated for three different scenarios: (1) when the firm issues a 3-month LIBOR debt, (2) when its debt is swapped and (3) when it enters a subsidized swap. Obviously, the resulting figures will be influenced by the value of the floating rate on each fixing date, whether it is lower or higher than the strike price. The following table summarizes the three scenarios:
| Floating Rate | Floating-Rate Debt | Swapped Floating-Rate Debt | Subsidized Swap |
|---|---|---|---|
| LIBOR ≤ 5.5% | LIBOR | 4.5% | 4.3% |
| LIBOR ≥ 5.5% | LIBOR | 5% | LIBOR- 1.2% |
When the 3-month LIBOR remains below the strike price 5.5%, the financing cost of the subsidized swap is equal to 4.5%-0.2% = 4.3%. When the 3-month LIBOR exceeds 5.5%, the firm has to pay (for a given period) LIBOR- 5.5% to the cap buyer. Its financing cost is then equal to 4.3% + LIBOR – 5.5% = LIBOR – 1.2%.
As the above example illustrates, the cap premium was used to reduce the fixed rate paid under the swap. The deal will result in a below market fixed swap, and it would revert to a below market floating rate swap when the cap is broken through.
Comments