Vega and Theta Companies can borrow for a five-year term at the following rates:

S&P's credit rating:

Vega: AAA

Theta: BBB

Fixed-rate borrowing cost:

Vega: 10.5%

Theta: 12.0%

Floating-rate borrowing cost:

Vega: LIBOR

Theta: LIBOR + 1%

(a) Calculate the quality spread differential (QSD). [3 marks]

(b) What is the necessary condition for a fixed-for-floating interest rate swap to be possible? [2 marks]

(c) Develop an interest rate swap in which both Vega and Theta have an equal cost savings in their borrowing costs. Assume Theta desires fixed-rate debt and Vega desires floating-rate debt and the parties agree with each other without having recourse to an intermediary. [10 marks]

(d) Now, assume more realistically that a swap bank is involved as an intermediary and is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat. Propose an interest rate swap in which both companies benefit equally. [10 marks]

(e) "Options can be traded on a variety of swaps." Explain the term swaption and differentiate between receiver and payer swaptions. [5 marks] [Total: 30 marks]