Q$3(26\%)$

$($a$)$ Suppose you operate a Canadian firm and would like to borrow $C$$$100,000$ to finance the business.

Because of the nature of your business, you would like to secure effectively floating$-$rate financing.

Your firm will need to pay interest rates of $6\mathrm{.}6\%$ and LIBOR $+2\mathrm{.}7\%$ if it borrows at fixed and floating

interest rates respectively. You are considering the possibility of reducing your financing costs by

setting up an interest rate swap with one of three companies $($Company $A,$ Company $B$ or Company

$C).$ Because of their business needs, all three companies need to secure effectively fixed$-$rate financing.

They face the following interest rates.

Setting up an interest rate swap with which of these three companies will result in the largest potential

reduction in financing costs? What is the lowest possible effective floating$-$rate financing cost $($in $\%)$

for your firm by entering into an interest rate swap with this company? Should your firm be a swap

buyer or a swap seller? Outline the terms of an interest rate swap that can equally split the total savings

in financing costs between your firm and that counterparty company.

$($b$)$ The followings are the financing costs of Firm D and E in fixed$-$rate and floating$-$rate markets:

Because of the nature of their business, Firm D needs to secure effectively fixed$-$rate financing, while

Firm E needs to secure effectively floating$-$rate financing. A financial institution is willing to be the

intermediary in an interest rate swap between Firm D and E if it can obtain at least $0\mathrm{.}2\%$ from the

swaps as fees. What is the range of value of $x$ in the following swap arrangement to ensure there are

incentives for all the parties $($Firm D$,$ Firm E$,$ and the financial institution$)$ to get involved? Note that

the financial institution will not be interested if it cannot secure a cash flow of at least $0\mathrm{.}2\%.$