Problem 1 (15 points)

Consider the borrowing costs faced by the following three companies:

Fixed Floating

A 3.0% LIBOR + 0.2%

B 3.9% LIBOR + 0.7%

C 4.8% LIBOR + 1.4%

Assume that if any two companies enter the swap transaction, they split the possible savings equally.

a) Company B and company C want to engage in the swap transaction. Find the range for the swap rate within which both companies would benefit from the swap?

B: 3.9% + LIBOR - X < LIBOR + 0.7%

X > 3.2%

C: LIBOR + 1.4% + X - LIBOR < 4.8%

X < 3.4%

Swap rate should be within the range 3.2% < X < 3.4 %

b) Suppose company B wants to borrow fixed-rate funds. Is it possible for B to reduce its cost of borrowing below 3.9%, and if so, what is the lowest possible cost it could achieve?

c) Suppose company B wants to borrow floating rate funds. Is it possible for B to reduce its cost of borrowing below LIBOR + 0.7%, and if so, what is the lowest possible cost it could achieve?