Question

*URGENT*

Two companies have investments which pay the following rates of interest:

	Fixed	Float
Firm A	6%	Libor
Firm B	8%	Libor+0.5%

Assume A prefers a fixed rate and B prefers a floating rate. Show how these two firms can both benefit by entering into a swap agreement. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B, then

1) what rates could A and B receive on their preferred interest rate? (1 mark)

2) Please draw the cash flow chart. (1 mark)

Part 1 Answer in the form of below:

	Fixed	Floating
Firm A
Firm B
Difference
Total gain to all the three parties (A, B and the intermediary)
Total gain to A and B

Part 2 in the form of:

Cash Flows of A	Cash Flows of B
Receives _____ from the outside borrowers	Receives _____ from outside borrowers
Pays ______ to the intermediary	Pay____ to the intermediary
Receives _____ from the intermediary	Receives ______ from the intermediary
Net effect: receives	Net effect: receives

Cash Flows of the intermediary

Receives _____ from Firm A

Pays _____ to Firm A

Receives ____ from Firm B

Pays _____ to Firm B

Receives: __________= 0.1%

Answer 1

SOLUTION:-

1) what rates could A and B receive on their preferred interest rate?

Part 1 Answer in the form of below:

	Fixed	Floating
Firm A	6%	LIBOR
Firm B	8%	LIBOR + 0.5%
Difference	2%	0.5%
Total gain to all the three parties (A, B and the intermediary)	2%-0.5% = 1.5% (to be distributed among A,B & intermediary)

Total gain to A and B Total gain to intermediary = 0.1 = 0.1 %

Total gain to A = = 0.70 %     Total gain to B = 0.70%

(as benefits are spread equally between Firm A and Firm B)

2) Please draw the cash flow chart.

Part 2 in the form of:

Cash Flows of A	Cash Flows of B
Receives LIBOR from the outside borrowers	Receives 8% from outside borrowers
Pays LIBOR  to the intermediary	Pay 6.80%  to the intermediary
Receives 6.70% from the intermediary	Receives LIBOR from the intermediary
Net effect: receives	Net effect: receives

Cash Flows of the intermediary

Receives LIBOR from Firm A

Pays 6.70% to Firm A

Receives 6.80% from Firm B

Pays LIBOR to Firm B

Receives: 6.80%-6.70%= 0.1%

The above solution of 2) can be understood more clearly by this diagram attached below :-