Assume that firms A and B can borrow at the fixed and floating rates listed below. Assume each firm is going to borrow in the market where it has a comparative advantage. After their initial borrowing, each firm wants to enter into a swap that will transfer its cash flows from fixed to floating or floating to fixed respectively.

a. Explain which firm has a comparative advantage in fixed and which has a comparative advantage in floating then diagram the swap based upon the comparative advantage and calculate the net interest paid effective rate paid) by each party, assuming that the financial institution gains .1% in fees and the other two banks benefit equally from the swap.

b. According to the idea of comparative advantage, both firms are able to borrow at a lower rate following the swap than they could have without the swap. Discuss if this is consistent or inconsistent with the idea that the rates the firms are charged for borrowing are a function of their risk (does the risk change their risk: if so, how and why does their riskiness change, if not why not and explain).

Firm	Fixed	Floating
A	3.6%	LIBOR + 2.2%
B	2.4%	LIBOR + 1.6%