Question

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%

Homework Answers

Answer #1
AAA BBB Calculation Difference
Fixed Rate 5% 7% 7% - 5% 2%
Floating Rate LIBOR+0.5% LIBOR+0.5% LIBOR+0.5% - LIBOR-0.5% 0
Net Difference 2% - 0 2%
As nothing is given, so it is assumed that fain is splitted equally.
Gain to each Party = 2%*50% = 1%
Effective Rate of Interest
Party Calculation Effective Rate
AAA LIBOR+0.5%-1% LIBOR-0.5%
BBB 7% - 1% 6%
So, Effective Swap Fixed Rate = 6%
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