a) Bonafide Ltd wishes to borrow 600 million euros for five years at a floating rate to finance an investment project in Italy. The cheapest rate at which it can raise such a loan is Euro Libor + 0.75%. The company’s bankers have suggested that one of their client companies Glossy, would be interested in a swap arrangement. This company needs a fixed interest loan of Euro 600 million. The cheapest rate at which it can arrange the loan is 10.5% per annum. It could, however, borrow in euros at the floating rate of Euro Libor + 1.5%. Bonafide Ltd can issue a fixed interest 5 year bond at 9% per annum interest. The banker would charge a swap arrangement fee of 0.15% per year to both parties. Assess whether a swap arrangement is possible and if so, devise the swap so that both parties can benefit. (7 marks)

(b) Discuss the benefits and shortcomings of interest rate swaps. (8 marks) (c) The treasurer of Company A expects to receive a cash inflow of $20,000,000 in 90 days. The treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is quoted at 5 percent. At expiration, LIBOR is 4.5 percent. Assume that the notional principal on the contract is $20,000,000.

(i) Indicate how can the treasurer hedge the interest rate risk by using the FRA. (4 marks)

(ii) Identify the specific type of FRA to be used here and explain the cash flows involved. (3 marks)

(iii) Calculate the gain or loss to Company A as a consequence of using the FRA as a hedging tool.