Reference no: EM13223073

You are the bank manager for a regional bank and you have a number of relatively large corporate organisations as clients. Recently you attended an internal training session organised by head office of the bank, at the training you learnt about some new products that the bank was introducing, including interest rate swaps, currency swaps and other forms of derivatives.

The following day you have a prearranged with James Lincoln the Chief Executive of Diamond Corporation Ltd (a diamond mining corporation and client of the bank), James indicates that he has a view that interest rates will fall and while he has a fixed interest loan comprising debentures issued for his business of $5,000,000, his company is paying 7% on these debentures he would like to be in a position to take advantage of the fall in interest rates and change the interest rate to a variable rate.

The following day, you are at a lunch with a friend Luke Washington, the Chief Executive of Random Trading Pty Ltd the company is not a client of your bank. Luke indicates that his company wants to borrow $5,000,000 for growth.

Luke also indicates that he is nervous about the having an exposure to potential rises in interest rates and asks your advice as to what he can do to reduce his perceived risk situation. Luke has received quotes from his bank to borrow the 5 million at a fixed interest rate of %10 or on a floating basis of BBSW plus 1%. He feels that 10% is too high and would be happy if he could fix his interest rate below 10% which he has been quoted from other bank. You say that you have an idea that may give him a better solution and that you will come back to him with a possible solution.

After returning to your office you remember you recent training on the new products and decide to investigate further, you review the information you have acquired about two companies which you summarise as follows;

Diamond Corporation

Debenture Loan amount; $5,000,000

Interest rate fixed at 7% for a further 3 years

Other information; credit rating of AAA

Random Trading

Loan amount required; $5,000,000

Term 3 years

Fixed rate loan; 10%

Variable Interest rate at BBSW plus 1% (Bank Bill Swap Rate)for a further 3 years

Other information; credit rating of ABB

Note BBSW(bank bill swap rate) is currently 5%.

Required

As the bank manager

1. What possible solution could you provide that would hedge the perceived interest risk at both companies? Provide a short note to each company outline the actions they should take, subject to approval by your bank, to achieve the interest rate exposures in line with each companies view on future interest rate movements .

2. Prepare a proposal document for the banks managementand risk committee for approval outlining the solution with a diagram explaining how your solution would help address the risk perspective of both organisations. It includes the bank making 0.5% from the arrangement.

3. Explain how

a. Both organisations will potentially benefit from the arrangement

b. What the overall net interest position could be for the companies