A firm can borrow at fixed AA rates minus 1% for long-term loans.If it swaps its long-term payments so that it receives the fixed AA rate and pays a AA floating rate,what is the rate of interest on its borrowing if the floating rate is r%?
A)r + 1%
B)r - 1%
C)r%
D)1%
E)2%

Question

Quizplus · Accepted Answer

The firm can borrow at fixed AA rates minus 1%, so the fixed AA rate is [floating rate + 1%]. 
When it swaps its long-term payments to receive fixed AA rate and pay a floating AA rate, it is receiving [floating rate + 1%] and paying [floating rate].

Therefore, the net effect of the swap is that they are effectively borrowing at [floating rate + 1%] and paying [floating rate].

This is equivalent to borrowing at [floating rate + (floating rate - 1%)] = [2 x floating rate - 1%].

Thus, if the floating rate is r%, the rate of interest on the borrowing is [2 x r% - 1%].

The closest answer choice is B) r - 1%.

A Firm Can Borrow at Fixed AA Rates Minus 1