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Firm AAA can borrow at 5% fixed or in the floating-rate market at LIBOR+0.5%. BBB can...

  1. Firm AAA can borrow at 5% fixed or in the floating-rate market at LIBOR+0.5%. BBB can borrow at 7% fixed or at LIBOR+0.5%. AAA wants to borrow floating and BBB fixed, so that they are interested in entering into an interest-rate swap. What is the swap fixed rate that is equally attractive to both firms? Assume that there is no financial intermediary involved in the swap transaction.

A) 7%                               B) 6.5%                      C) 6%                         D) 5.5%

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Answer #1

Firm AAA can save 2% (7%-5%) over firm BBB in fixed rate borrow. neither of the firms has any advantage in the floating rate borrowing.

To make the things equally attractive, firm AAA should bowwor fixed @5% and lend to BBB at 6%. This way they will earn 1% extra. (half of the benefit of 2%)

Also, firm BBB will borrow at LIBOR+0.5% and will lend to AAA at the same rate. Firm BBB net savings will be 1% as they will have the fixed rate loan @6%. Equal benefit for both.

Answer : 6%

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