Problem 1:

Company A and B can borrow for a 3-year term at the following rates. While A desires fixed rate borrowing, B prefers floating rate borrowing.

            Fixed Rate       Floating Rate

A          8.5%                LIBOR + 0.5%

B          7%                   LIBOR

The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.5%.

1) Illustrate how Company A benefits from the use of interest rate swap.

2) Summarize the risks taken by the swap bank in the interest swap with Company B.

3) Is it feasible for the swap bank to customize an interest rate swap that provide a cost saving of 0.35% to B? Explain.

4) Suppose both Company A and B entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5% - 7%. Which company is willing to unwind the original swap? Explain how much it is willing to pay to unwind.