Lluvia Manufacturing and Paraguas Products both seek funding at the lowest possible cost. Lluvia would prefer the flexibility of floating rate borrowing, while Paraguas wants the security of fixed rate borrowing. Lluvia is the more credit-worthy company. With the better credit rating, Lluvia has lower borrowing costs in both types of borrowing.

Assumptions		Lluvia		Paraguas
Credit rating		AAA		BBB
Prefers to borrow		Floating		Fixed
Fixed-rate cost of borrowing		9.000%		12.000%
Floating-rate cost of borrowing:
LIBOR		4.000%		4.000%
Spread		1.000%		2.000%
Total floating-rate		5.000%		6.000%

The two companies are considering a swap contract to reduce their borrowing cost. The net effect of the swap will allow Lluvia to borrow at floating rate and Paraguas to borrow at fixed rate.

Please answer the following questions:

1. According to comparative advantage, should Lluvia Manufacturing borrow at fixed rate OR floating rate before it enters the swap contract?
2. Design a swap contract for these two companies and show how these two companies can save money (assuming the two companies share the cost saving equally from the swap contract). Remember to include the borrowing each company needs before the company enters the swap contract.