Consider an interest rate SWAP between firm AAA and firm BBB. AAA wants to borrow at a floating rate while BBB wants to borrow at a fixed rate. Suppose AAA is a conservative firm that can borrow in the fixed rate market at 9% and in the floating rate market at LIBOR - 0.5%, while BBB, being a more risky firm, can borrow in the fixed rate market at 11% and in the floating rate market at LIBOR + .8%. The financial intermediary (FI) that arranges the SWAP receives a commission of 0.1%. If AAA and BBB enter into an interest rate SWAP whereby AAA and BBB each lower the rate they pay by the same amount, then:

a) Verify that the total benefit to be shared is .7%. Note that the FI will take .1% of this leaving .3% each as the benefit for AAA and BBB as a result of the SWAP. What effective rates do AAA and BBB pay as a result of the SWAP?

b) Identify the payments that AAA and BBB each make to either the FI or to the market.