Reference no: EM131543654

(a) Jane Doe is the treasurer of Bowling Green Toys Inc (BGT). David Smith is the CFO of the company. BGT has $100 millions cash in its local bank account. Jane Doe and David Smith realize that BGT does not need to use the funds in the next two years. Currently, the funds are invested in a 3-month CD in a local bank. Jane Doe intends to let the funds continue to roll over into consecutive 3-month CDs. The interest on the CD is tied to LIBOR. After studying the newly released economic data, Jane Doe is confident that interest rate will move lower gradually in the next two years. Thus, as a floating interest rate index, LIBOR will also decrease in the next two years. She recommends to David Smith to engage in an interest rate swap.

(i) Briefly explain how an interest rate swap agreement can benefit BGT. Be specific about the pay-fixed position. Provide your answer in less than 40 words.

(ii) John Smith understands Jane’s intention. He, however, also recalls a concept called efficient market. He told Jane, “I think that interest rate swap is fine. But if the market is efficient, other corporate treasurers will interpret the same data as you do and they will engage in similar interest rate swaps. Then, we can’t find a swap counterparty.” Jane disagrees. Provide one reason to help Jane to explain that there are still many swap counterparties available. [note: assume efficient market is correct]