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Two companies in chemical industry are P and Q. The high quality borrower (P) prefers to raise $50 million in five years floating rate funding.

Two companies in chemical industry are P and Q. The high quality borrower (P) prefers to raise $50 million in five years floating rate funding. The low quality company (Q) prefers to raise $50 million in five years fixed rate funding. This is explained in table presented below.

Type of borrowers

Fix

Float

Coy P

5%

L-0.50%*

Coy Q

7%*

L+0.50%

Required

  1. A)Explaininwhichratedoes(P)and(Q)hascomparativeadvantage.WhatisthestrategytocreateaswapcontractbetweenPandQ?Whatarethegainsfromswap?(5marks)

  1. B)
  2. LetX=totalbasispoint.ShowthatnetcashoutflowtoPisL-2%+XandQis7.50%-X.Suppose.49%and.51%thenexplainhowthenetcashoutflowofeachpartiessatisfytheoverallgainfromswapof1%underthetwoXvalues.(3marks).

C)

  1. A range of values is possible for X that satisfies the Pareto-improvement condition. For example If X = 1.0% explain the net cost to each parties and show that your results matches gains from swap in part (a). (4 marks)

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