Hi, I only need help with 1 and 2, thank you! Company A and B can borrow for a 3

Question

Hi, I only need help with 1 and 2, thank you!

Company A and B can borrow for a 3-year term at the following rates. While A desires fixed rate borrowing, B prefers floating rate borrowing. The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% -7.5%. Illustrate how Company A benefits from the use of interest rate swap. Summarize the risks taken by the swap bank in the interest swap with Company B. Is it feasible for the swap bank to customize an interest rate swap that provide a cost saving of 0.35% to B? Explain. Suppose both Company A and B entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5% - 7%. Which company is willing to unwind the original swap? Explain how much it is willing to pay to unwind.

Explanation / Answer

1. A's choice of borrowing is at Fixed rate. The borrowing available to A at fixed rate is available at 8%. On the other hand, if A borrows under swap, his rate will actually come out to 7% in the first year, 7.25% in the second year, and 7.50% in the third year. Therefore, A will save 1% in the first year, 0.75% in the second year, and 0.50% in the third year.

2. Swap bank will offer the company B with floating interest rate borrowings at LIBOR, in case the LIBOR becomes lower than the market interest rate at which Swap bank is able to borrow the funds, then Swap Bank will be at loss. This is the risk.

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