Question

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%

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%