Companies A and B have been re

Companies A and B have been required the following rates perannum on a $10 million notional:
Fixed rate Floating rate
Company A 2.0% p.a. LIBOR + 0.3% p.a.
Company B 3.0% p.a. LIBOR + 1.3% p.a.
a)Under which assumption Company A and B may find it useful toenter a swap?
b)In that case, design a swap that will net a bank, acting asintermediary, 0.2% per annum and that will appear equallyattractive to both companies.
How does your answer to question b) modify if A is availableto receive 1/3 of the amount that is shared between A and B (i.e.,the overall gain minus the intermediary fee is split into threeparts, one for A and two for B)?
Plus: when B-A(float) equals to B-A(fixed) how to determine Band A chose floating or fixed markets?


Fixed Floating
A 0.3% LIBOR + 2%
B 1.3% LIBOR + 3%
Company A External vendor B
Pay 0.30% LIBOR+2%
Hence net rate of borrowing = (LIBOR + 2%) – 0.30% = LIBOR +1.7% If A borrowed directly, i.e. w/o the swap, its rate would beLIBOR + 2% Hence A is better off by 0.3% for using the swap.
Company B External vendor A
Pay 1.3% LIBOR+3%
Hence net rate of borrowing = (LIBOR + 3%) – 1.3% = LIBOR -1% If B borrowed directly, i.e. w/o the swap, its rate would beLIBOR + 3% Hence B is better off by LIBOR-1% for using theswap.
We now consider the case with a financial intermediary
We have the following constraints:
1 Net gain to financial intermediary is 0.2%.
2 Net gain to A must equal net gain to B since deal must beequally attractive to both companies.
External lender <…………….. A FI B ……………………..>External lender
0.30% <………………………… <………………………… LIBOR+3%
…………………………> …………………………>
We need to find the values ofx and y that will satisfy the constraints imposed.
From constraint (1), we have for FI thatCash Inflow – Cash Outflow = 0.2 => (y+L)-(x+L)=0.2 =>y-x=0.2 (3)
Gains from using Swap We determine the netcash outflow,
Hence gain from using swap over doing
Direct Gain (A) = Net cash outflow – Costof direct floating rate loan for A = [(L+0.3)-x] –[L+0.2]=0.1-x
Direct Gain (B) = Net cash outflow – Costof direct fixed rate loan for B = [y+L+3-L]-1.3=y-0.7
To satisfy (2), we must have
Gain (A) = Gain (B) => 0.1-x = y -0.7=> y+x = 0.8 (4)
We can then solve equations 3 & 4simultaneously to get : x=0.7-0.2=0.5 & y=0.7 Thus the swappayments will be as follows:
Company A
• Pay 0.3%% to outside lender
• Pay LIBOR to FI
• Receive 0.7% from FI
Hence net rate of borrowing for A=0.3% +LIBOR -0.7%=LIBOR-0.4%
Company B
• Pay LIBOR+0.3% to outside lender
• Pay 0.5% to FI
• Receive LIBOR from FI
Hence net rate of borrowing for B:=LIBOR+0.3% + 0.5%-LIBOR = 0.8%

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