Consider two firms, Larss plc and Sousa plc. Larss plc has a better credit rating and can borrow cheaper than Sousa plc in both fixed and floating rate markets.

Specifically, Larss pays 6.35 per cent fixed and LIBOR plus 0.5 per cent floating. Sousa plc pays 9.85 per cent fixed and LIBOR plus 1.5 per cent floating.

(a) If Larss plc prefers to borrow floating and Sousa plc prefers to borrow fixed, determine the spread differential that they will split if they do a swap with each other.

(b) Construct a swap in which both Larss plc and Sousa plc can exploit Sousa plc’s comparative advantage. Your answer should include a swap diagram and a description of the cash flows transferred as a result of the swap.

(c) Describe what is meant by a currency swap and the conditions under which a company may wish to undertake this type of transaction.