B.F.

Goodrich-Rabobank Interest Rate Swap

Case Analysis

OFS Assignment II
COMPARATIVE COST ADVANTAGE:
Fixed
10.7% (AAA Eurobonds)
Rabobank (AAA)
B.F. Goodrich (BBB-)
Rabobanks
Advantage

12.5% (BBB industrials)

Floating
LIBOR + 0.25% (foreign
government guaranteed
Notes)
LIBOR + 0.5%

1.80%

0.25%

Comparative advantage = 1.8 % - 0.2 5% = 1.55 % p.a.

Rabobank has advantage in both the fixed and the floating rate markets.
However, Rabobank needs floating rate financing to support its U.S. dollardenominated floating rate loans and B.F. Goodrich needs fixed rate financing for
long term to support its deteriorating financial condition.

TRANSACTIONS AND NEEDS FOR EACH PARTY:

B.F.Goodrich
Transaction:
1. It pays the bond holder in US bond market at (LIBOR+0.5)%
2. It receives from Morgan Bank at (LIBOR-x)%

3. It pays to Morgan Bank at fixed rate of 10.7% compounded semi-annually i.e.

$5.5mn/year
4. It pays to Morgan bank an initial fee of $125000 and a fixed fee f
Needs
1. It wanted fixed-rate money but borrowing from market would be very costly
because of its low credit rating.
2. It wants to enter into a swap so that it is able to get money at a fixed rate and
that too at a rate cheaper than the market rate.
Morgan Guaranty Bank
Transaction:
1. It receives from B.F.Goodrich at fixed rate of 10.7% compounded semiannually i.e. $5.5mn/year
2. It receives from B.F.Goodrich an initial fee of $125000 and a fixed fee f
3. It pays to B.F.Goodrich at (LIBOR-x)%
4. It pays to Rabobank at 10.7% compounded semi-annually
5. It receives from Rabobank at (LIBOR-x)%
Needs:
1. The primary reason why Morgan bank came into the swap was it reduced the
interest rate at which the swap was taking place because of its superior credit
rating.
2. Due to this it received an initial amount of $125000 and a fixed annual
amount f from B.F. Goodrich.
Rabobank
Transaction:
1. It pays the bond holder in the Eurobond market a fixed rate of 10.7%
compounded semi-annually.
2. It pays to Morgan Bank at (LIBOR-x)%
3. It receives from Morgan Bank at 10.7% compounded semi-annually.
Needs:
1. It wanted floating rate bond from US market.
2. It wanted that the interest it would be paying should be less and its going with
a swap with B.F.Goodrich with Morgan Bank as intermediary would help it
pay less interest rate as both the banks have AAA ratings.

Structure of the Swap:

In the figure below,

X = Discount paid to Rabobank by BF Goodrich through Morgan Bank.

F = Undisclosed annual fee to be given by Goodrich to Morgan Bank for
next 8
years.
C = Equivalent Coupon rate of the one time fee ($ 125,000) paid by BF
Goodrich
to Morgan Bank.
All interest rates are annual rates with semiannual compounding.

For the $125000 one time payment, lets assume that a fixed rate coupon is being
paid annually.
Discounting rate used = 10.70% ( =11% annual rate compounded annually)

So, C = 0.024 % (Annualized rate for semiannual compounding)

Cost of Financing:
Before the swap:
Rabobank cost of financing = LIBOR +0.25 (Floating Foreign Govt. Guaranteed
Notes)
B.F. Goodrich cost of financing = 12.5% (BBB industrial Bond Rate)
After the Swap:
Rabobank cost of financing =

10.7% (Fixed Eurobond rate)

+ (LIBOR - x) (swap payments to Morgan)
- 10.7% (swap payments received from Morgan)
--------------------------------= LIBOR x

B.F. Goodrich cost of financing =

LIBOR +0.5% (interest to investors in the U.S.)
+ 10.7% (Annual Coupon payments to Morgan)
+ F (undisclosed annual fee to Morgan)
+C(Equivalent coupon rate of the one time initial fee)
- (LIBOR - x) (swap payments received from Morgan)
------------------------------= 11.224 % + F + x

Swap Transaction Savings:

Rabobank savings = (LIBOR +0.25) (LIBOR x) = 0.25 + x > 0.(1)
B.F. Goodrichs savings = 12.5% - (11.224 % + F + x ) = 1.276 - F x >0..(2)
Morgans Fee = C + F = 0.024 + F(3)
--------------------------------------------------Total Savings = Rabobank savings + B.F. Goodrich savings + Morgans Fee
= 1.55% (Equal to the total Comparative Advantage Calculated)

Range of X and F:
For the deal to be attractive to all parties, the three equations from 1 to 3 should
be satisfied.
Solving those,
X should be greater than -0.25%. But since it makes no sense for Rabobank to
pay the discount (i.e. x<0), so x should be greater than 0. (otherwise no incentive
for Rabobank)
X should be less than 1.276 % (otherwise no incentive for B.F. Goodrich and/or
Morgan)
F should be greater than zero (otherwise no incentive for Morgan)
F should be less than 1.276 % (otherwise no incentive for Rabobank and/or B.F.
Goodrich)
Hence, 0% < x < 1.276%
And 0 < F < 1.276%
In this case, the risk due to defaults in payment from B.F Goodrich to Rabobank
has been absorbed by Morgan Bank for which it takes a fee from B.F Goodrich.
As it is, there is no defaulting risk concerning Rabobank as it is being paid more
by Morgan Bank than it is paying it.
All the three parties are gainers in this transaction. However from the above
equations, we can see that, F + x < 1.276.
Since the values of F and x are unknown, exact gains of the parties involved
cant be said.