ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market; it prefers to borrow at fixed rate and can borrow funds either at 11 percent fixed rate or at LIBOR + 2.5 percent floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It prefers to borrow at floating rate and can borrow funds either at 9 percent fixed rate or at LIBOR + 4.5 percent floating rate.

(a) Is there an opportunity here for ABC and XYZ to benefit by means of an interest rate swap?

(b) Suppose you have just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients ABC and XYZ. Describe how you could bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2.0 percent profit. Assume that ABC and XYZ will share the benefit equally.

(c) Draw the graph to reflect the relation among the dealer, Company ABC and Company XYZ in this interest rate swap.