1. ABC Co. is planning to borrow $25 million for 5 years. In the market, it can obtain a fixed rate loan with annual interest payments at 5% or a floating rate loan at T-bill+4%. XYZ Co. is planning to borrow $25 million for 5 years. In the market, it can obtain a fixed rate loan with annual interest payments at 8½% or a floating rate loan at T-bill + 6¾%.
a. Explain what a swap broker would recommend each company do so the swap broker can structure a parallel loan arrangement with each company giving each a better net loan deal than it can get in the market, and the swap broker can realize a profit.
Indicate (1) which loan each company should obtain in the market, what the terms of the loan (2) from each company to the swap broker and (3) from the swap broker to each company should be, (4) what the total net payment is for each company (as a percent of the $25 million), and (5) the profit the swap broker realizes on each payment (in dollars).
b. Specify the equation for a swap that will replace the parallel loan arrangement with each company in part a. (Standard notation for an interest rate swap is: Notional Principal*(Fixed Rate - Floating Ratet), or Notional Principal*(Floating Ratet - Fixed Rate).