Consider a plain vanilla interest rate swap.Firm A can borrow at 8 percent fixed or can borrow floating at LIBOR.Firm B is somewhat less creditworthy and can borrow at 10 percent fixed or can borrow floating at LIBOR + 1 percent.Eun wants to borrow floating and Resnick prefers to borrow fixed.Both corporations wish to borrow $10 million for 5 years.Which of the following swaps is mutually beneficial to each party and meets their financing needs?
A)Firm A borrows $10 million externally for 5 years at LIBOR; agrees to swap LIBOR to firm B for 8 ½ percent fixed for 5 years on a notational principal of $5 million; B borrows $10 million externally at 10 percent.
B)A borrows $10 million externally for 5 years at LIBOR; agrees to pay 8½ percent to B for LIBOR fixed for 5 years on a notational principal of $5 million; B borrows $10 million externally at 10 percent.
C)Since the QSD = 0 there is no mutually beneficial swap.
D)A borrows $10 million externally at 8 percent fixed for 5 years; agrees to swap LIBOR to B for 8½ percent fixed for 5 years on a notational principal of $5 million; B borrows $10 million externally at LIBOR + 1 percent.

Question

Quizplus · Accepted Answer

In this scenario, Firm A wants to borrow floating and Firm B prefers fixed. Therefore, Firm A should borrow externally at 8% fixed for 5 years and then swap LIBOR to Firm B at 8.5% fixed on a notational principal of $5 million. This will allow Firm A to benefit from the lower LIBOR rate, while Firm B benefits from the higher fixed rate. Firm B can then borrow externally at LIBOR +1% to meet their financing needs. This swap is mutually beneficial to both parties as it allows them to access financing at their preferred rates while mitigating their respective risks.

Consider a Plain Vanilla Interest Rate Swap