Firm A can borrow at LIBOR + 150 basis points or fixed at 5%

Firm B can borrow at LIBOR + 350 basis points or fixed at 11%

Preliminary Questions

(a) In order for there to be a swap that will generate a gain what must be true?

(b) If the condition described in part (a) holds, what is the total amount of the gain generated from the swap? NOTE: calculate the total interest paid if Firm A borrows at the variable and Firm B borrows at the fixed. Assume the LIBOR is equal to 3%. Then calculate the total interest paid if Firm A borrows at the fixed and Firm B borrows at the variable. The difference is the gain.

(c) Explain why that number makes sense?

(d) Lets tell a story where there is no swap bank involved yet. Lets show the case where Firm A captures all of the benefit from the swap.

(e) Lets tell a story where there is no swap bank involved yet. Lets show the case where Firm B captures all of the benefit from the swap.

You are the manager of a swap bank and you want to quote a rate at which you pay the LIBOR and a rate at which you will take a LIBOR and pay the fixed. You want the two rates to be such that that both firms will want to make the swap and will generate a profit of % for the swap bank.

That leaves 3.5% for Firm A and firm B. Lets assume that A captures 2% of the gain and B captures 1.5% of the gain.

Our task: find the rates the swap bank quotes such that all of these conditions are fulfilled.