Interest Rate Swap with Financial Intermediary

Two companies have investments which pay the following rates of interest:

Firm A: Fixed 6%; Float LIBOR

Firm B: Fixed 8%; Float LIBOR + 0.5%

• Firm A requires fixed rate. Firm B requires floating rate.
• Gross total advantage is 2% - 0.5% = 1.5%
• Intermediary charge is 0.1% each. Therefore, intermediary total charge is 0.1% * 2 = 0.2%.
• Net total advantage is 1.5% - 0.2% = 1.3% total. The benefits will be spread equally between Firm A and B. Therefore, 1.3% / 2 = 0.65% each.

Show how Firm A and Firm B can benefit from entering into a swap agreement.

Q1. What rates could Firm A and Firm B receive on their preferred interest rate?

Q2. Draw the swap diagram.