Question: Firm A can borrow at 4% fixed or in the floating rate market at Libor flat. Firm B can borrow at 7% fixed or at

Firm A can borrow at 4% fixed or in the floating rate market at Libor flat. Firm B can borrow at 7% fixed or at Libor+100bps. A wants to borrow floating and B fixed. Suppose that to reduce financing costs, A borrows fixed, B borrows floating, and they enter into an interest-rate swap. Which of the following statements is valid?

Please explain your answer thoroughly.

a) The combined improvement in cost of financing to A and B with the swap is always equal to the difference between the fixed rate differential (between A and B) and the floating rate differential which in this case is 200 bps.

b) The combined improvement in cost of financing to A and B with the swap is always equal to the floating rate differential, which in this case is 100 bps.

c) The combined improvement in cost of financing to A and B with the swap depends on the negotiated fixed rate on the swap between the two counterparties.

d) No improvement in combined financing costs is possible what one party gains in financing cost, the other party loses.

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