3. A company issues a leveraged floating-rate note with a face value of $5,000,000 that pays a coupon of 2.5 times Libor. The company plans to generate a profit by selling the notes, using the proceeds to purchase a bond with a fixed coupon rate of 7% a year, and hedging the risk by entering into an appropriate swap. A swap dealer provides a quote with a fixed rate of 6% and a floating rate of Libor. Discuss whether the company should enter into a swap involving paying fixed, receiving floating or paying floating, receiving fixed.

Calculate the amount of the arbitrage profit the company can earn by entering into the appropriate swap. In your answer, indicate the cash flows generated at each step. Also explain what additional risk the company is taking on by doing the swap.