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Swaps to reduce costs
Swaps can be used to reduce the costs
of borrowing by swapping interest payments with another company. We can
illustrate this with an example of two companies Focusnet and Heavyhitter.
Both Focusnet and Heavyhitter want to borrow £100,000,000 but
Heavyhitter can borrow at cheaper rates because it has a stronger balance
sheet. The two companies have been quoted two different costs for borrowing
at variable and fixed rates which have been shown below.
Fixed rate %
Variable rate %
LIBOR + .5
LIBOR + 1
Now lets say that Heavyhitter wants a variable rate and Focusnet wants a a
If Focusnet borrows the money it wants it will cost them
£10 million a year in interest. If Heavyhitter borrows the money it wants it
will cost them LIBOR + .5 in interest. if LIBOR is 5% then the total annual
cost would be £5.5 million per year. The total borrowing on £200 million per
year would be £15.5 million.
If instead each of these companies borrows the money in which they have the
greatest comparative advantage both companies can reduce their costs.
Providing the companies swich the interest payment obligations. Usually it
is the stronger company that can claim the bulk of the saving. We can
illustrate this with an example.
Lets say that Heavyhitter borrows £100 million at a fixed rate of 5.5% and
Focusnet borrows a £100 million at LIBOR + 1 which would be 6%. Now now the
position of Focusnet is as follows it pays 6% on its loan to the bank, but
lets say that Heavyhitter pays part of Focusnets loan the part being LIBOR
(the LIBOR part of the loan which is 5%). Its net cost or out of pocket cost
would be £1 MILLION. Meanwhile Heavyhitters payments are £5.5 million per
year but lets say that it receives 8 million a year from Focusnet. This
would give heavyhitter a saving income of £2.5 million. since its total
annual payment will then be £5million - £2-5 million for a toal payout of
£2.5 million. Focusnet would have had to borrow at 10% but through the swap
is borrowing a 100 million at £8 million plus the 1million cost over LIBOR
it has to pay on its original loan for a toal cost of £9 million. so
Focusnet is saving £1 million pounds per year by by using the swap.
In practise swaps are set up by banks as an arrangment for two property
companies and they will charge a fee for this.