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Rothmans Inc The Curious Case Of The Interest Rate Swap Case Solution

Solution Id Length Case Author Case Publisher
1798 1034 Words (4 Pages) Karen Lightstone Ivey Publishing : W12164
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In an interest rate swap, the risks associated with the fluctuation in interest rate is hedged through entering into a contract in which one party agrees to pay the fixed rate and the other pays a floating rate in return. This hedges the risk, as when the party considers the interest rates to be highly volatile and go upwards; it will likely fix the interest rate (Liu, Longstaff and Mandell 2006). 

Following questions are answered in this case study solution

  1. Was Rothmans wise to enter into an interest rate swap? Why? 

  2. After examining the fair value calculation provided, discuss the implications of using a different discount rate.

CAD Govt Bonds

Canada Savings Bonds

4.71

1.3

4.27

2.75

3.71

4

3.52

1.65

3.98

2.75

Average Rate

Average Rate

5.04

2.49

Fair value of Swap

Fair value of Swap

5.14

5.17

3. Explain what the termination cost means in the audited financial statements of March 31, 2003 (see exhibit 6 of the case)

Case Analysis for Rothmans Inc The Curious Case Of The Interest Rate Swap Case Solution

Rothman was wise to enter into an interest rate swap. He locked in the fixed rate in exchange for the floating rate comprising of the banker’s acceptance and the variable 150 basis points. This was not the wise decision for the short run since the bond issued by Rothman was through the Canadian bank only, which was the counter party of the swap. Thus, the discount rate used to value them generated a higher number, resulting in Rothman to pay higher interest on the bonds issued in the short term. Had Rothman entered into the floating rate swap, he would have paid even more in interest payment as the banker’s acceptance rate fluctuated by a greater proportion as compared the fixed-rate valuation. Since the banker’s acceptance is expected to continue to reach spike high levels, fixed terms of payment helped give Rothman benefit in terms of lower fixed interest rate (Duffie and Liu, Floating–fixed credit spreads 2001).

 2. After examining the fair value calculation provided, discuss the implications of using a  different discount rate.

CAD Govt Bonds

Canada Savings Bonds

4.71

1.3

4.27

2.75

3.71

4

3.52

1.65

3.98

2.75

Average Rate

Average Rate

5.04

2.49

Fair value of Swap

Fair value of Swap

5.14

5.17

The discount rates are the rates that are used to discount the swap related cash flows. The implications of using different discount rates therefore directly influence the fixed swap rate as that is calculated based on the floating rate, which is pre-decided. The discount rate that is used at the time of the setting of swap is important, as it is the main determinant of the fixed interest rate that will be used as the swap payment (Duffie and Huang, Swap rates and credit quality 1996). Thus, higher the discount rate taken at the beginning of the swap period, lower the fixed-rate calculated will be which would have been favorable for Rothman as there was a difference, which Rothman could benefit from, had he considered the implications of using different discount rates for swap valuation and would have attempted to use a higher discount rate. Therefore, it can be concluded that the use of discount rates at the beginning of the swap period for the calculation of swaps need to be properly calculated. This would help avoid locking in a fixed rate, that would result from a lower discount rate as this rate would be higher than could potentially be. In the case of a higher discount rate being used to value a swap at the start of the period, a lower fixed rate can be locked which would help in substantially reducing the interest payments for the party (Lekkos and Milas 2001). 

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