Greg Williams, from Cardinal Point,one of our guest speakers in the first part of the class, recently completed the renovations on a condo project in Central Florida. Greg will borrow money to pay off the construction loan and can borrow at the 3 month LIBOR rate plus 1.5% or at 7% fixed rate. USAA, a large property insurer, keeps its reserves for future payments for storm damage invested in short- term securities. It can finance that investment at the 3 month LIBOR rate plus .75% or at 3.5% fixed. The capital markets team at HFF, a large commercial real estate firm, knows about the Greg's financing needs and USAA's financing needs.

HFF proposes that Greg and USAA each borrow where they have a relative advantage. As part of an interest rate swap, the Greg will pay HFF 5% and HFF will pay Greg the 3 month LIBOR rate plus 1%. HFF will pay USAA 4.25% and USAA will pay HFF the 3 month LIBOR rate plus 1%.

a.Do you think Greg should prefer fixed or floating rate financing for the condo project. Briefly, why? Answer the same question for USAA.

b.Define and compute the Quality Spread and demonstrate mathematically that Greg, USAA and HFF are all better off with the proposed interest rate swap than without it. Then explain how the benefits to the two borrowers and the swap arranger are related to the Quality Spread.

c. If Greg decides on floating rate financing he can use an interest rate cap to protect himself from rising interest rates. Briefly explain how an interest rate cap works to provide protection to borrowers.If it was your project, would you borrow at a fixed rate or borrow floating and use an interest rate cap given current market conditions. Explain, briefly. Use at least two of the eleven trends in the HFF presentation in your answer.

d.The floating rate component of this swap is tied to the LIBOR rate. Briefly explain what the LIBOR rate is and why it is being replaced.