Your bank made a 3-year fixed-rate loan to Fresh Corporation at 8.50 percent. The ALCO wants only to accept floating rate loans so that it can reduce its liability sensitivity. Using the following information, indicate what position the bank should take to convert this fixed-rate loan to a floating rate loan in the best possible manner. The current prime rate is 8.5 percent and three month LIBOR is 5.5%

Three-Year Basic	Pay 8.22%; Receive three-month LIBOR
Interest Rate Swap	Pay three-month LIBOR; Receive 8.17%

Bid/Offer Premium
Three-year interest cap on prime rate	8.25% cap	8.50% cap	9.00% cap
Premium	0.71/0.68	0.52/0.47	0.20/0.15
Three-year interest cap on Three-month LIBOR	5.50% cap	5.75% cap	6.00% cap
Premium	0.95/0.90	0.70/0.64	0.47/0.42

Describe what position you would take with an interest rate cap. Which index (prime or LIBOR) would you use? Explain why. Which strike rate would you use? Explain. Assume that the bank take this position.

A. Suppose that LIBOR and prime rate rise by 1 percent after one year and remain at this higher level for the next 2 years. What will the effective loan yield equal?

B. Suppose that LIBOR and prime rate fall by 0.75 percent after one year and remain at this higher level for the next 2 years. What will the effective loan yield equal?