Lockheed wants 5-year floating rate debt in USD. 5-year IRS = 4%. SOFR = 4.15%. It could issue 5-year fixed rate at 4.5% or 5-year FRNs at SOFR + 1%. What should it do?

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Question restatement: Lockheed wants 5-year floating rate debt in USD. Given 5-year IRS = 4%, SOFR = 4.15%, the firm can issue a 5-year fixed rate at 4.5% or 5-year FRNs at SOFR + 1%. Which option should it pursue?

Option 1: 'Issue 5-year FRNs and pay fixed on an IRS. This will give Lockheed what it wants while profiting from the slope in the yield curve.' This is inconsistent with the nature of FRNs. FRNs are designed to pay a variable coupon tied to a reference rate (SOFR in this case), not a fixed rate. Paying fixed on an IRS against FRNs would create a fixed-for-floating mismatch that defeats the purpose of issuing FRNs. So this option describes a structure that would not actually be an FRN and would not deliver true floating-rate debt.

Option 2: 'Issue 5-year fixed rate and pay floating on an IRS. There is low demand for Lockheed FRNs.' Here, the proposed structure is a fixed-rate issue with a floating-rate payment on an interest rate swap (IRS). This would be an unconventional and internally contradictory arrangement: a fixed-rate instrument would not typically involve paying floating on an IRS unless there’s an embedded swap, which would add complexity and misalignment with the objective of issuing floating-rate debt. Moreover, the claim about low demand for FRNs is speculative and not directly addressing the core objective of obtaining floating-rate funding.

Option 3: 'Issue 5-year FRNs. They want floating rate debt, and there’s no free lunch.' This option aligns with the stated objective: 5-year FRNs pay a coupon equal to a reference rate (SOFR) plus a spread (SOFR + 1%), delivering genuine floating-rate exposure. Considering SOFR is 4.15%, the expected all-in coupon would be around 5.15% initially, which is higher than the 4.5% fixed rate, and thus matches the company’s preference for floating funding rather than fixed. The phrase 'there’s no free lunch' correctly conveys that choosing floating FRNs trades off the potential benefit of upside or familiarity with fixed-rate advantages against the complexity and cost of floating-rate funding, and there isn’t a magical cheaper option that perfectly fits all criteria without trade-offs.

Summary of reasoning:
- FRNs are floating-rate instruments; option 1 misstates the nature of FRNs by proposing a fixed payment on an IRS, which is inconsistent with floating debt.
- Option 2 suggests a fixed-rate issue tied to an IRS with floating payments, which is structurally odd and does not directly deliver floating-rate debt as requested, plus it relies on speculative demand assumptions about FRNs.
- Option 3 correctly identifies that issuing 5-year FRNs delivers floating-rate exposure (SOFR + 1%), which matches the objective, while acknowledging that there are no 'free lunches'—there are trade-offs relative to fixed-rate financing, such as exposure to reference rate movements and spread Premiums.

IFEPIA7022_001_2025_3 - Economics of Finance EOF Midterm

Lockheed wants 5-year floating rate debt in USD. 5-year IRS = 4%. SOFR = 4.15%. It could issue 5-year fixed rate at 4.5% or 5-year FRNs at SOFR + 1%. What should it do?

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IFEPIA7022_001_2025_3 - Economics of Finance EOF Midterm

Lockheed wants 5-year floating rate debt in USD. 5-year IRS = 4%. SOFR = 4.15%. It could issue 5-year fixed rate at 4.5% or 5-year FRNs at SOFR + 1%. What should it do?

View Explanation

Log in for full answers

Similar Questions

GHI Industries has issued $180 million worth of long-term bonds at a fixed rate of 14%. GHI Industries then enters into an interest rate swap where it will pay LIBOR and receive a fixed 6% on a notional principal of $180 million. After all these transactions are considered, GHI's cost of funds is:

The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:

An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an:

Part 1Interest rate swaps have an advantage over options and futures in​ that:Part 2 A. There is a large market for them. B. They can be written for a long time horizon. C. They are more liquid. D. They can limit interest rate risk.

AIG Co. expects interest rates to rise over the next 12 months. To hedge its floating-rate loan, the company should:

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A swap that technically is a succession of forward contracts on interest rates is

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

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