Response to the following problem:
A manufacturing firm, Banner Products, is seeking to raise $50 million by issuing a seven-year bond. The CFO is seeking fixed-rate financing. However, Banner Products' investment banker has informed the CFO that it could synthetically create a fixed-rate bond at a lower cost if it issued floating-rate bonds and used an interest rate swap. If the fixedrate bonds are issued, the interest rate that Banner Products must offer is 9%. If floating-rate bonds are issued, the rate would be three-month LIBOR plus 200 basis points. The swap would be a seven-year swap that pays quarterly with a notional amount of $50 million. In the swap, Banner Products would pay 6.7% and receive three-month LIBOR.
a. Diagram the payments that must be made by Banner Products if it issues a floating-rate bond and at the same time enters into the swap.
b. What is the rate on the synthetic fixed-rate bond created and compare this rate to that of a fixed-rate bond that Banner Products could have issued?
c. What risk is Banner Products exposed to by creating a synthetic fixed-rate bond?