Firm A and Firm B need to raise $100,000,000 of debt to pay for their projected capital expenditures. Firm A is a blue chip company with a high credit rating in the corporate debt market. It can borrow funds at either 10.75% fixed rate or at LIBOR + % floating rate. Firm B is a new firm which is not yet well established and presently has a relatively low credit rating in the corporate debt market. It can borrow at 11.70% fixed rate and at LIBOR + 3/8 % floating rate. A bank dealer has agreed to organize a fixed for floating interest rate swap between these two firms. The bank has agreed to charge a % fees to structure this transaction.
a) What is the size of the Quality Spread Differential (QSD) involving Firm A and Firm B? What does it capture?
b) Organize a swap agreement where the total QSD is distributed among all participants.