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A financial institution has brought together two firms who seek access to new debt capital for expansions of their operations.

Company AAA is concerned about rising interest rates and seeks fixed rate financing, while company BBB is prepared to take what it believes to be the attractive current variable rate which is on offer.

The two firms have existing arrangements in place for sources of financing, however AAA can attract funds from the Eurodollar market at what it believes to be beneficial rates.

AAA: Fixed: 7%

AAA: Floating: LlBOR+3.5%

BBB: Fixed: 9%

BBB: Floating: LIBOR+6.5%

1. Assuming no transaction costs, clearly indicate the size of any observed mispricing of risk. <) mark)
2. Clearly indicate any absolute advantage in financing. Why is this likely to be the case? (I mark)
3. Clearly indicate any comparative advantages in financing. (I mark)
4. The financial institution helps to create a swap which is beneficial to both parties and requires a net total compensation package of 0.2% of the total funds involved (this does not mean 0.2% from each company, this means 0.2% total compensation). Assume that any available benefits are split evenly between the two companies and design a swap which is acceptable to both companies and to the financial institution. Clearly indicate the swap rates that the two companies and the financial institution arc using. Clearly indicate the final borrowing rate for each company. (4 marks)