Question 3 (15 Marks) (a) Prawn and Lobster are two companies that can borrow for a five year term at the following rates. Prawn Lobster International credit rating A B Fixed-rate borrowing cost 6.5% 10.5% Floating-rate borrowing cost LIBOR + 1% LIBOR + 3% (i) Calculate the quality spread differential (QSD). Enter your answer as a percentage to 2 decimal places, e.g. 1.23 (1 Mark) 2.00 % (ii) Develop an interest-rate swap in which both Prawn and Lobster have an equal cost savings in their borrowing costs. Assume that Prawn desires floating-rate debt and Lobster desires fixed-rate debt. No swap bank is involved in the transaction. Assume that the payments are all made against flat Libor. Assume that Libor is currently 4%. (4 Marks) Fill in the blanks. Enter answers as one of the following formats. Numbers should be percentages to 2 decimal places, e.g. 1.23, LIBOR, LIBOR + 1.23 Prawn would borrow at a rate of 6.5 % from their bank. Lobster would borrow at a rate of LIBOR+3.00 % from their bank. Prawn will pay LIBOR * to Lobster. Lobster will pay 6.5% + to Prawn. Prawn's all in cost is LOBOR % Lobster's all in cost is 9.5 %(iii) Based on the information above suppose a swap bank is offering the following quote on USD Libor 7.1 - 7.2 Under this scenario Prawn will pay to the swap bank and Lobster will pay . (2 marks) Based on this calculate the gain (in basis points) for: Swap Bank - bps (1 mark) Prawn - bps (1 mark) Lobster - bps (1 mark) (b) The current spot exchange rate is EUR1.45 / USD 1.00, and the one year forward exchange rate is EUR1.4163 / USD 1.00. The one-year interest rate is 5% in euros and 4.5% in US dollars. You can borrow USD 4,000,000, or the equivalent EUR amount today, at the current spot exchange rate. (i) Show how you can make a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Round all figures to the nearest number. (4 Marks) Fill in the blanks. Borrow in currency and convert to currency for a total value of in currency (ii) Calculate the size of the arbitrage profit. (1 Mark) The arbitrage profit should be in currency