Firm A can borrow at 4% fixed or at Libor flat in the fixed and floating rate markets,respectively.Firm B can borrow at 7% fixed or Libor plus 100 bps in the fixed and floating rate markets,respectively.A wants to borrow floating and B wants to borrow fixed. If A borrows fixed and B borrows floating and they enter into a fixed-for-Libor interest-rate swap in which A pays Libor flat,what is the range of fixed rates for B that enables each firm to improve its financing costs (compared to accessing financing in the market directly)?
A)4%-7%
B)4%-6%
C)5%-6%
D)5%-7%

Question

Quizplus · Accepted Answer

The two parties would enter into a swap at say 5% fixed versus floating Libor.Then,A would borrow at a fixed 4%,and B would borrow floating at Libor plus 1%.The net result is that A would obtain floating rate borrowing at a net financing cost of Libor minus 1% (cheaper than accessing floating finance at Libor in the open market).B would obtain net fixed rate financing at 6% (1% lower than accessing it directly).It is easy to calculate that in this case both have gained by accessing financing that is 1% cheaper,i.e. ,together they obtained a gain of 2%.We can also see that the fixed rate can be at 4% in which case the entire gain of 2% goes to B,or the fixed rate can be at 6% in which case the entire gain would go to A.Anything outside these bounds would not work,as then one of the parties would be better off borrowing without the swap.

Firm a Can Borrow at 4% Fixed or at Libor