This questions comes up frequently as part of a long question in final exams but with different numbers] Given the following information: Borrower Fixed rate Floating rate AAA 8.00% p.a. LIBOR BBB 10.00% p.a. LIBOR + 0.50% p.a.

a. Determine whether a profitable interest rate swap could be arranged between AAA Limited and BBB Limited.

b. If a profitable swap is possible, construct a swap that would advantage both parties. Indicate which party should borrow at a fixed rate using a bond issue and which party should borrow at a floating rate via a bank loan.

c. Construct a swap diagram between the counterparties (without an intermediary), showing diagrammatically the direction of cash flows and the various interest rates used in the swap (including borrowing costs) and indicate the net outcome for each party.

d. Discuss whether the two parties have to share any savings equally and what the impact on costs of considering the presence of an investment bank intermediating this contract (frequently, this is arranged by investment banks).

e. The notional principal of the swap agreement is USD 1million. Explain the concept of notional principal.