Two multinational FIs enter their respective debt markets to issue $100 million of two-year notes. FI A can borrow at a fixed annual rate of 11 percent or a floating rate of LIBOR plus 50 basis points, repriced at the end of the year. FI B can borrow at a fixed annual rate of 10 percent or a floating rate of LIBOR, repriced at the end of the year.
a. If FI A is a positive duration gap insurance company and FI B is a money market mutual fund, in what market(s) should each firm borrow so as to reduce its interest rate risk exposure?
b. In which debt market does FI A have a comparative advantage over FI B?
c. Although FI A is riskier than FI B and therefore must pay a higher rate in both the fixed-rate and floating-rate markets, there are possible gains to trade. Set up a swap to exploit FI A's comparative advantage over FI B. What are the total gains from the swap? Assume a swap intermediary fee of 10 basis points.
d. The gains from the swap can be apportioned between FI A and FI B through negotiation. What terms of swap would give all the gains to FI A? What terms of swap would give all the gains to FI B?
e. Assume swap pricing that allocates all gains from the swap to FI A. If FI A buys the swap from FI B and pays the swap intermediary's fee, what are the realized net cash flows if LIBOR is 8.25 percent?
f. If FI A buys the swap in part (e) from FI B and pays the swap intermediary's fee, what are the realized net cash flows if LIBOR is 11 percent? Be sure to net swap payments against cash market payments for both FIs.
g. If all barriers to entry and pricing inefficiencies between FI A's debt markets and FI B's debt markets were eliminated, how would that affect the swap transaction?