ABC and XYZ need to raise funds to pay for capital improvements at their manufacturing plants. ABC looks for a fixed-rate financing while XYZ targets a floating-rate loan. ABC is a well-established firm with an excellent credit rating in the debt market, and it can borrow funds either at 6.0% p.a. fixed rate or at LIBOR + 1.75% p.a. floating rate. XYZ is a new technology start-up firm without a strong credit history. It can borrow funds either at 7.50% p.a. fixed rate or at LIBOR + 4.75% p.a. floating rate.

a.What is the interest rate difference in borrowing fixed-rate loans between the two companies? What is the difference in borrowing floating-rate loans? Explain which company has a comparative advantage in fixed-rate loans and which company has a comparative advantage in floating-rate loans. What are the potential savings for an interest rate swap between the two companies? (7 marks)

b.With the help of a diagram, design an interest swap between ABC and XYZ that will allow each of them to share benefits equally. (6 marks)

c.Evaluate the net effect on the cash flows (net borrowing cost) of both companies involved. How many basis points of interest rate could both companies save from the swap contract? (6 marks) Consider that a portfolio manager is holding $100 million of long- term 8% coupon bonds and wishes to reduce price risk by transforming the holdings into a synthetic floating rate portfolio. He expects that the interest rate is going to increase. Assume that the portfolio currently pays an 8% fixed-rate income and that swap dealers currently offer terms of 8% fixed for LIBOR.

d.What swap would the portfolio manager establish? (6 marks)