QUESTION :Two companies have investments which pay the following rates of interest: Fixed Float Firm A 6% Libor Firm B 8% Libor + 0.5% Assume A prefers a fixed rate and B prefers a floating rate. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B, what rates could A and B receive on their preferred interest rate? Show all working.

ANSWER: The difference between fixed rates of the two firms = Fixed rate of B Fixed rate of A = 8%-6% = 2% = 200 basis points The difference between floating rates of the two firms = Floating rate of B Floating rate of A = Libor +0.5% -Libor = 0.5% = 50 basis points For each of the firms either fixed or floating is more preferred depending on where they have a comparative advantage. Firm A prefers fixed rate while Firm B prefers floating rate. The spread of their comparative advantage is given by difference in fixed and floating spreads of the firms which is = 200 basis points 50 basis points = 150 basis points This difference in spreads can be used by both the firms to reduce the cost of investments. Intermediary fees for each firm = 0.1% =10 basis points Total intermediary fees = 0.1% * 2 = 0.2% = 20 basis points Total spread available to firms after intermediarys fees = 150 basis points 20 basis points = 130 basis points Both A and B can receive rates of 65 basis points on their preferred interest rates. A would get 6.65% Fixed while B would get Libor +1.15%.

REQUIRED: Please illustrate this answer in a diagram explaining clearly the flow of interest. Thank you!