In the solution of a problem below - how is number 8.5 (Paraguas pays Lluvia fixed) calculated ?: Lluvia Manufacturing and Paraguas Products both seek funding at the lowest possible cost. Lluvia would prefer the flexibility of floating rate borrowing, while Paraguas wants the security of fixed rate borrowing. Lluvia is the more credit-worthy company. They face the following rate structure. Lluvia, with the better credit rating, has lower borrowing costs in both types of borrowing.
Lluvia wants floating rate debt, so it could borrow at LIBOR+1%. However it could borrow fixed at 8% and swap for floating rate debt. Paraguas wants fixed rate, so it could borrow fixed at 12%. However it could borrow floating at LIBOR+2% and swap for fixed rate debt. What should they do?
Assumptions		Xavier		Zulu
Credit rating		AAA		BBB
Prefers to borrow		Floating		Fixed
Fixed-rate cost of borrowing		8.000%		12.000%
Floating-rate cost of borrowing:
LIBOR (value is unimportant)		5.000%		5.000%
Spread		1.000%		2.000%
Total floating-rate		6.000%		7.000%
Comparative Advantage in Borrowing		Values
Lluvia's absolute advantage:
in fixed rate borrowering		4.000%
in floating-rate borrowing		1.000%
Comparative advantage in fixed rate		3.000%
One Possibility		Xavier		Zulu
Lluvia borrows fixed		-8.000%		---
Paraguas borrows floating		---		-7.000%
Lluvia pays Paraguas floating (LIBOR)		-5.000%		5.000%
Paraguas pays Lluvia fixed		8.500%		-8.500%
Net interest after swap		-4.500%		-10.500%
Savings (own borrowing versus net swap):
If Lluvia borrowed floating		6.000%
If Lluvia borrows fixed & swaps with Paraguas		4.500%
		1.500%
If Paraguas borrowes fixed				12.000%
If Paraguas borrows floating & swaps with Lluvia				10.500%
				1.500%
The 3.0% comparative advantage enjoyed by Lluvia represents the opportunity set for improvement for both parties. This could be a 1.5% savings for each (as in the example shown) or any other combination which distributes the 3.0% between the two parties.