Question

Two firms X and Y are able to borrow funds as follows:

Firm A: Fixed-rate funding at 3.5% and floating rate at Libor-1%.

Firm B: Fixed-rate funding at 4.5% and floating rate at Libor+2%.

Assume A prefers fixed rate and B prefers floating rate. Show how these two firms can both obtain cheaper financing using a swap. What swap strategy would you suggest to the two firms if you were an unbiased advisor? What is the net cost to each party in the swap? Show your work in detail.

give the answer and solution in detail

Answer 1

	A has absolute advantage in both rates, but the advantage is
	more in Floating rate. It is (L+2%)-(L-1%) =			3.00%
	B has comparative advantage in Fixed rate = 4.5%-3.5% =			1.00%
	Advantage from swap to A & B.			2.00%
	To be shared by A & B: A = 1.50%, B = 0.50%.
	A		B
		3.50%
		---------------->
L-1%				4.50%
<-----------------------				----------------------->
		<-----------------
		L+0.5%
	Net rate to A = -(L-1%)-3.5%+(L+0.50%) = 2.00%			Gain for A = 3.5%-2.0% = 1.50%
	Net rate to B = -4.50%-(L+0.50%)+3.50% = L+1.5%			Gain for B = (L+2%)-(L+1.5%) = 0.50%