Student Educational Loan Fund Inc Case Solution

The company needs to enter into multiple derivative transactions in order to completely hedge its risk from the floating rate payments. The fixed for floating derivative instruments are usually structured around LIBOR. This could be the reason that the banks have not provided the company with a derivative to convert its prime lending rate into a fixed rate. The different fixed for floating options provided by the bank feature around LIBOR. Therefore, the company needs to enter into the basis swap in order to convert its prime lending rate into LIBOR. As part of the transaction, no payments will be made at the initiation of the contract. The company will pay the LIBOR rate and receive PRIME rate less 2.80%. Therefore, the company will be receiving 2.8% less than the prime rate that it has to pay. However, the LIBOR rate that the company now has to pay on the basis swap is also a variable interest rate. Therefore, the company still needs to hedge its floating-rate risk on the LIBOR.

The company has two options to do that. One option is that the company can buy a cap and sell a floor on the same notional amount (equal to the amount of the loan). The interest rate on both the cap and the floor can be 6%. This way, the company will receive a payment if the LIBOR rises above 6%. The amount of receipt will equal LIBOR minus 6%. On the other hand, the company will make a payment if LIBOR falls below 6%. The amount of the payment will equal 6% minus LIBOR. The effect of such a transaction will be such that SELF will end up paying an interest rate of 6% regardless of the floating rate of LIBOR. This transaction also involves an upfront payment. The company will have to pay 1.52% of the notional amount when buying a cap, and receive 2.52% of the notional amount when selling the floor. The net effect of the transaction will be that SELF will receive a net upfront payment equal to 0.60% of the notional amount. The alternative option is for SELF to purchase a fixed-for-floating SWAP contract. Under such a contract, SELF would receive the floating rate in exchange for paying a fixed rate of 5.76%. There will be no upfront payments under such a swap contract. Each of these options has its own merits. Under the sale of floor and purchase of cap option, the company will not only pay a higher interest rate of 6%, but also receive an upfront payment equal to 0.6% of the notional amount of the contract. Under the fixed-for-floating swap, the company will have to pay a lower interest rate of 5.76%, but it will not receive any upfront payments. It is believed that the upfront payment is of no economic consequences under the circumstances, and the company should aim to minimize its interest payments. Moreover, the fixed-for-floating swap is simple and easy to terminate if the need arises due to prepayments. Therefore, the company should enter into the fixed-for-floating interest swap.

In a nutshell, SELF should enter into two separate derivative transactions in order to convert its floating-rate interest obligation into a fixed-rate obligation. The company should enter into a fixed-for-floating interest rate swap where it will pay a fixed rate of 5.76% in exchange for receiving the LIBOR. The company should then enter into a basis swap where it will pay the LIBOR that it received from the vanilla swap and received the prime rate less 2.80%. Effectively, the company will have to pay a fixed rate of 8.56% (5.76% + 2.80%) in order to repay its interest obligations. The company should therefore charge its customers a rate equal to 8.56% plus a premium for its costs and required return. For instance, if the company believes that a spread of 3% will compensate for its overhead and required return on equity, it can charge a fixed rate of 11.56% on its loans. The derivative contracts will ensure that the company continues to earn its spread even if the prime rate changes.

2. How should SELF deal with the prepayment problem? What is the impact of prepayment problem on the rate charged to students? 

SELF permits its borrowers to prepay their loans without any additional charges. This had led to uncertainty regarding the future cash flows of the company. It is hard to predict when the borrowers will be making a prepayment on the loan. Although the prepayments have coincided with employee bonuses, it can be difficult to predict the amount and timing of the prepayments. This situation can get worse in the future. In the past, the borrowers paid a variable interest rate on their loans. Therefore, the motivation to prepay the loans was low because when the interest rate level dropped, the interest payments on the loan also decreased. The situation has changed with the fixed-rate loan. SELF will now be charging a fixed rate on its loans, regardless on the floating interest rate.