Company A and B Essay Example | Topics and Well Written Essays - 750 words

Company A and B - Essay Example mpany A and Company B arrange a derivative to be transacted on the 1st April 2014 so that Company A pays fixed interest over the period and Company B pays floating rate interest over the period. Assuming that the fixed interest rate agrees with the Company A is LIBOR + 7% (fixed at inception), that LIBOR is 0.5% on April 1 2014 and that on June 30, 2014 the LIBOR rate raises from 0.5% to 1%. a) Describe the derivative trade that would enable such an exchange, the reasons why each company might want to transact such a derivative and calculate what the swap rate would be for Company A at inception. A derivative is a security whose value is dependent or derived from its underlying assets. The derivative represents a contract agreement between two or more parties. Its price is affected by any slight changes in its original assets. Some common underlying assets include bond’s interest rates stocks, commodities, currencies and market indexes. The major characteristic of derivatives is high advantage. For the case of company A and B would adopt the interest rate swaps as described below Interest rate swap occurs when Party A agrees to pay Party B through a fixed interest rate, and the counterpart Party B agrees to pay Party A through a floating/variable interest rate which is attached to a reference rate (the most used reference rate is the London Interbank Offered Rate, LIBOR).Each counterpart in a swap has a "comparative advantage" in a different credit market and it is through such an advantage in a particular market that is used to obtain an equal advantage in a another separate market to which credit access was denied. Companies in the two different markets agree to an exchange deal in which a fixed rate is exchanged with a floating/variable interest rate loan. In this case Company B prefers liabilities which are floating but would prefer a fixed loan rate. It is therefore prudent that enters into a swap with company A and exchange its fixed rate loan for