FRM Case Assignment

BF Goodrich-Rabobank Interest
Rate Swap
Presented by
Group 8
Kewal Boricha(084)
Nabil Abdulla P K(091)
Rohit Kumar Gaurav(102)
Ronak Chaudhary(155)

BF Goodrich and Rabobank

In the early 1980s BF Goodrich needed to raise new funds, but

its credit rating had been downgraded to BBB-. The firm needed
$50,000,000 to fund continuing operations. BF Goodrich needed
fixed rate financing for long term to support its deteriorating
financial condition.

They wanted long term debt in the range of 8 to 10 years and a

fixed rate. Treasury rates were at 10.1 % and BF Goodrich
anticipated paying approximately 12 to 12.5%

Rabobank

Rabobank was a large Dutch banking organization consisting of

more than 1,000 small agricultural banks. The bank was
interested in securing floating rate financing on approximately
$50,000,000 in the Eurobond market. Rabobank needs floating
rate financing to support its U.S. dollar-denominated floating rate
loans.

With a AAA rating Rabobank could issue fixed rate in the

Eurobond market for approximately 10.7% and for a floating rate
of LIBOR plus .25%

The Intermediary

Salomon Brothers suggested a swap agreement to each party

This would require BF Goodrich to issue the first public debt tied
to LIBOR in the United States. Salomon Brothers felt that there
would be a market for the debt because of the increase in
deposits paying a floating rate due to deregulation.

Problems

Rabobank was interested in the deal, but fearful of credit risk. A

direct swap would expose it to credit risk. Without an active
swap market it was common for swaps to be arranged between
the two counter parties

The two finally reached an agreement to use Morgan Guaranty as

an intermediary.

The agreement

BF Goodrich issued a noncallable 8 year floating rate note with a

principal value of $50,000,000 paying the 3 month LIBOR rate
plus .5% semiannually. The bond was underwritten by Salomon

Rabobank issued a $50,000,000 non callable 8 year Eurobond

with annual payments of 11%

Both entered into a swap with Morgan Guaranty

The swaps

BF Goodrich promised to pay Morgan Guaranty 5,500,000 each

year for eight years (matching the coupon on the Rabobanks
debt). Morgan agreed to pay BF Goodrich a semi annual rate tied
to the 3 month LIBOR equal to: .5(50,000,000)(3 mo LIBOR-x)
x represents an undisclosed discount

Rabobank received $5,500,000 each year for 8 years and paid

semi annul payments of LIBOR-x

Cost of Financing

Before the swap:

Rabobank cost of financing = LIBOR +0.25%
B.F. Goodrich cost of financing = 12.5%

After the Swap

Rabobank cost of financing =
10.7%
(interest to investors in Netherlands)
+ (LIBOR - x) (swap payments to Morgan)
- (10.7%)
(swap payments received from Morgan)
-----------------= LIBOR - x

B.F. Goodrich cost of financing =

LIBOR +0.5%
(interest to investors in the U.S.)
+ 10.7% + F
(swap payments plus fee to Morgan)
- (LIBOR - x) (swap payments received from Morgan)
--------------------= 11.2% + F + x

Swap Transaction Savings

Rabobank savings = 0.25% + x > 0

B.F. Goodrich savings = 1.3% - F - x > 0
Morgans fee = F > 0
---------------------------------------------------------------------Total = 1.55% = Comparative cost advantage
Minimum and Maximum for x and F

x should be greater than -0.25% (otherwise no incentive for Rabobank)

x should be less than 1.3% (otherwise no incentive for B.F. Goodrich
and/or Morgan)

F should be greater than zero (otherwise no incentive for Morgan)

F should be less than 1.55% (otherwise no incentive for Rabobank
and/or B.F. Goodrich)

Hence, -0.25% < x < 1.3%

And
0 < F < 1.55%

Swap Diagram
Morgan Guaranty
LIBOR-X
%

10.7%
+F
Goodrich

LIBOR+.5%
Effective Rate=11.2%
+F+X

LIBOR-X
%

10.7%

Rabobank

10.7%
Effective Rate=LIBOR-X
%

The intermediary role

The two swap agreements were independent of each other

eliminating the credit risk concerns of Rabobank

Morgan received a one time fee of $125,000 paid by BF Goodrich

plus an annual fee of paid by BF Goodrich.

BF Goodrich

Assuming that the discount from LIBOR was 50 Bp and that the
service fee was 22.5 BP (the midpoint of the range). BF Goodrich
paid an all in cost of 11.925 % annually compared to 12.5% if
they had issued the debt on their own.

Rabobanks Position

At the time of financing it would have paid LIBOR plus 25 to 50

Bp. Given that it paid no fees and the fixed rate canceled out it
ended up paying LIBOR - x

Other Issues

Default Risk

The evolution of interest rate swaps and LIBOR