(a) Black plc has a £50 million ten-year floating-rate loan from Bank A at LIBOR +150 basis points. The treasurer is worried that interest rates will rise to a level that will put the firm in a dangerous position. White plc is willing to swap its fixed-interest commitment for the next ten years. White currently pays 9 per cent to Bank B. Libor is currently 8 per cent. Show the interest-rate payment flows in a diagram under a swap arrangement in which each firm pays the other’s interest payments. 

(b) What are the drawbacks of this swap arrangement for Black? 

(c) Black can buy a ten-year interest-rate cap set at a Libor of 8.5 per cent. This will cost 4 per cent of the amount covered. Show the annual payment flows if in the fourth year Libor rises to 10 per cent. 

(d) Describe a ‘floor’ and show how it can be used to alleviate the cost of a cap.