1.Consider Firms A and B who each want to borrow $40 million for 1 year. The firms face the following borrowing costs:

Fixed Floating

Firm A 5% LIBOR

Firm B 5.5% LIBOR + 0.2%

A swap bank offers the following swap rates against US dollar LIBOR flat: 5.1-5.2%. Assume the 1-year US dollar LIBOR is 3%.

a.Draw a diagram showing the flow of interest payments (including dollar amounts) among the three parties suppose A issued fixed rate debt and B issued floating rate debt.

b.Is it beneficial for the firms to enter into the swap agreement in part a with the swap bank? How much will each of the parties earn or lose in the swap agreement?