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Swaps to reduce costs

Swaps can be used to reduce the c
osts 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.

                                       Heavyhitter                        Focusnet              Difference
Fixed rate %                     5.5                                      10                         4.5
Variable rate %              LIBOR + .5                       LIBOR + 1                0.5

Now lets say that Heavyhitter wants a variable rate and Focusnet wants a a fixed rate.
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.


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