A corporate treasurer tells you that he has just negotiated a 5-year loan at a competitive fixed rate of interest of 5.2%. The treasurer explains that he achieved the 5.2% rate by borrowing at 6-month LIBOR plus 150 basis points and swapping LIBOR for 3.7%. He goes on to say that this was possible because his company has a comparative advantage in the floating-rate market. What has the treasurer overlooked?
Credit risk is the risk of a counterparty defaulting on its contractual obligations, either the principal or the timely interest repayment, a downgrading of credit quality. This can be hedged using Credit Default Swaps.
Answer and Explanation:
The treasurer had missed to factor in the situations where the company might not be able to roll over the swap agreement at the existing rate. The swaps may also include clauses for early termination of the contract under certain specified conditions. For example, consider a situation where the credit rating of the company deteriorates, then it might not be able to raise roll over the contract at same 150 basis points spread and any amount more than 150 points would then become the interest rate for the existing period. Not only that, but there is also counterparty risk in these swaps, as these are over the counter derivatives.
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from Finance 305: Risk ManagementChapter 1 / Lesson 4