(a) Goslow Ltd wishes to borrow GBP 800 million for six years at a floating rate to finance an investment project in UK. The cheapest rate at which it can raise such a loan is Libor + 1.75%. The companys bankers have suggested that one of their client companies Glorycom, would be interested in a swap arrangement. This company needs a fixed interest loan of GBP 800 million. The cheapest rate at which it can arrange the loan is 10.5% per annum. It could, however, borrow in sterling at the floating rate of Libor + 2.5%. Goslow Ltd can issue a fixed interest 6 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 Alphonsa Co. Ltd. expects to receive a cash inflow of $40Million 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 considers a Forward Rate Agreement (FRA) that expires in 90 days and which is based on 90-day Libor. The FRA is quoted at 5.2 percent. At expiration, Libor is 4.7 percent.

(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 Alphonsa Co. Ltd as a consequence of using the FRA as a hedging tool. (8 marks)