7. Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage the company’s financial risks.

Two years ago, Rone issued a $25 million (U.S.$), five-year floating-rate note (FRN). The FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is noncallable and will be repaid at par at maturity.

Scott expects interest rates to increase, and she recognizes that Rone could protect itself against the increase by using a pay-fixed swap. However, Rone’s board of directors prohibits both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combination of capital market instruments.

a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required transactions.

b. Explain how the transactions in part a are equivalent to using a pay-fixed swap.