Question: Except where otherwise specified, all interest rates are stated as annual rates.

1. Identify two ways a swap differs from a parallel loan.

2. Firm X wants to borrow $10m for 2 years with quarterly interest payments and the entire principal payable at maturity. It has found that it can borrow in the market at L+4?% or at a fixed rate of 6¼%. Firm Y also wants to borrow $10m for 2 years with quarterly interest payments and the entire principal payable at maturity. It has found that it can borrow in the market at L+3¾% or at a fixed rate of 5¼%.

a. Explain what market borrowing and parallel loan transactions a swap broker could propose to Firms X and Y so that the net interest payment for each firm is at a lower-than-market rate, with the swap broker also realizing a profit.

b. Calculate the interest savings for each firm relative to the market (as a percentage of $10m) and the total profit for the swap broker (also as a percentage of $10m) if the arrangements proposed in part a is followed.

c. Specify the terms of swap agreements for each firm in place of the proposed parallel loans that gives each firm and the swap broker the same net result as the parallel loans proposed in part a.