You work for a large bank which provides funding for a number of firms across Europe. Gauging the funding demand from clients, you have identified some interest-rate swap opportunities that could potentially lower their borrowing costs. The following table provides information about the funding costs for two of your clients ABC and TLP:

While ABC prefers to borrow in the variable-rate market, TLPs preference is to borrow in the fixed-rate market. You propose an interest-rate swap deal to your clients. ABC is particularly unimpressed with your proposal. They argue that an interest rate swap with TLP is a disaster and only benefits TPL because ABC can borrow at both fixed and variable debt at more attractive rates than TLP.

A) Explain to ABC why they might benefit from the swap. Make sure that your explanation includes the discussion about the absolute and comparative advantages and the potential savings from the interest rate swap deal?

B) Now show both clients that the interest rate swap will work by completing the diagram below with the following assumptions: 1) ABC will have 50% of the potential savings, and TLP will receive the rest 2) To maintain long-term relationship with both clients, the bank will not receive any commission from the current swap. Not that you can have multiple correct answers.

LIBOR (floating rate) must be used in the transaction between ABC and TLP companies i.e. either transaction (iii) or (iv).

Fixed-Rate Variable-Rate ABC 12% LIBOR + 2% TLP 13.5% LIBOR + 2.5% (iii) ABC TLP (iv) Borrows Borrows (0) (ii) Fixed-Rate Variable-Rate ABC 12% LIBOR + 2% TLP 13.5% LIBOR + 2.5% (iii) ABC TLP (iv) Borrows Borrows (0) (ii)