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% |

Question (1)
Firm “A” prefers to borrow float-rate while firm “B” prefers to
borrow fixed-rate. “A” is offered 4.5% fixed rate and LIBOR float
rate, while “B” is offered 6% fixed rate and LIBOR+0.5% float rate.
If both firms approach you as an MSF elite graduate for a
consultation to reduce their borrowing costs, suggest (voluntarily)
an interest rate swap structure where “A” benefits 75% of the cost
reduction and “B” benefits 25% of the cost reduction.
A
B
Issue...

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Assume that there is no financial intermediary involved in the swap
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A) 7% B) 6.5% C) 6% D) 5.5%

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A)
7%
B)
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Firm AAA can borrow at 5% fixed or in the floating-rate market
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A)
7%
B)
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C)
6%
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