Part III Derivatives Market and Hedging Risk

Question 11: Interest Rate Swap

Company A is a blue chip company, headquartered in United State. It is considering raising $500 million to fund its major expansion in a whole new sector for the next 20 years. Company A can either borrow at a fixed rate of 11% or at a floating rate of prime rate + 7%. Given company A's own projection of its new business, it prefers to borrow at floating rate.

Company B is multi-national corporation based in France. It is also considering raising $500 million to expand its business in United States for the next 20 years. Company B can either borrow at a fixed rate of 15% or at a floating rate of prime rate + 9%. Company B prefers to borrow at fixed rate.

a. Explain the comparative advantage between company A and company B when it comes to borrowing.

b. Suppose you represent a swap bank and now both companies ask you to create an interest rate swap that would help both company save 0.8% in the interest annually. (Company A save 0.8% in floating rate and company B save 0.8% in fixed rate)

c. What is the net profit for your bank annually?