1.Two multinational corporations enter their respective debt markets to issue $100 million of two-year notes. Firm A can borrow at a fixed annual rate of 11 per cent or a floating rate of LIBOR plus 50 basis points, repriced at the end of the year. Firm B can borrow at a fixed annual rate of 10 per cent or a floating rate of LIBOR, repriced at the end of the year.

If Firm A is a positive duration gap insurance company and Firm B is a money market mutual fund, in what market(s) should each firm borrow so as to reduce their interest rate risk exposures?

In which debt market does Firm A have a comparative advantage over Firm B?

Although Firm A is riskier than Firm B, and therefore must pay a higher rate in both the fixed-rate and floating-rate markets, there are possible gains to trade. Set up a swap to exploit Firm A’s comparative advantage over Firm B. What are the total gains from the swap trade? Assume a swap intermediary fee of 10 basis points.

The gains from the swap trade can be apportioned between Firm A and B through negotiation. What terms of trade would give all the gains to Firm A? What terms of trade would give all the gains to Firm B?

Assume swap pricing that allocates all the gains from the swap to Firm A. If A buys the swap from B and pays the swap intermediary’s fee, what are the end-of-year net cash flows if LIBOR is 8.25 per cent?

If Firm A buys the swap in part

(e) from Firm B and pays the swap intermediary’s fee, what are the end-of-year net cash flows if LIBOR is 11 per cent? Be sure to net swap payments against cash market payments for both firms.

If all barriers to entry and pricing inefficiencies between Firm A’s debt markets and Firm B’s debt markets were eliminated, how would that affect the swap transaction? LO 7.7