Question
Kath and Kim each wish to borrow $5 million for five years, but Kath prefers to borrow at fixed rate while Kim prefers floating. However,
Kath and Kim each wish to borrow $5 million for five years, but Kath prefers to borrow at fixed rate while Kim prefers floating. However, Kim has a higher credit rating and has an absolute advantage in borrowing at both floating and fixed rate. They have obtained the following quotations for borrowing:
| Fixed Rate | Floating Rate |
Kath | 4% p.a. | Libor + 0.5% p.a. |
Kim | 3% p.a. | Libor - 0.25% p.a. |
A swap dealer quotes a mid-rate of 3.4% p.a. against Libor and pays 5 basis points less than the mid-rate and receives 5 basis points more.
i) Design an on-market plain vanilla swap which will reduce both Kath and Kims borrowing costs and provide them with their preferred form of borrowing. Indicate what values are required for the letters A to F on the above diagram.
ii) By engaging in this swap, how much will Kath be able to reduce her cost of borrowing below the market alternative for her preferred borrowing type?
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