SMOOTHING Corporation’s Treasurer finds that he should increase the existing proportion of the company’s floating rate interest payments. An interest rate swap appears to be a good way of doing so while achieving the lowest possible floating rate.

The company has an AAA credit rating and pays fixed rate interest at only 5.50% and floating rate interest at six-month Euro Libor + 0.25%. If SMOOTHING enters into a swap deal exchanging fixed rate for floating rate obligations with the right company, it could achieve an even lower effective floating rate.

For example, Company X could be such a candidate even though its credit rating is only BBB. Company X must pay 6.5% on its fixed rate borrowing and would like to reduce this by means of a swap. It pays Euro Libor+ 0.75% on floating rate debt. If CompanyXis the right candidate, SMOOTHING could achieve a lower floating rate and Company X could obtain a lower fixed rate, and both would therefore gain fromthe swap transaction.

(a) Calculate the combined gain for the two companies if SMOOTHING and Company Xtransact the swap.

(b) What floating rate would SMOOTHING pay Company X and what fixed rate must Company X pay SMOOTHINGto make the division of the combined gain equal?

(c) A swap bank intermediates such transactions. What is the maximum the swap bank could charge for this service without making the proposed swap unattractive?