Problem:

ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market; it can borrow funds either at 11 percent fixed rate or at LIBOR + 1 percent floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It can borrow funds either at 10 percent fixed rate or LIBOR + 3 percent floating rate.

Required:

Question 1: Is there an opportunity here for ABC and XYZ to benefit by means of an investment rate swap?

Question 2: Suppose you've just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients, ABC and XYZ. Describe how you would bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2 percent profit.

Note: Show all workings.