Reference no: EM13831979

ISWAP/USWAP

ISWAP is a nonfinancial firm with a weak financial condition. Local banking institutions are willing to offer ISWAP only variable-rate loans. A fixed-rate loan would be more desirable, in light of a long-term investment in a new product that it is contemplating. USWAP is a large, strongly capitalized bank in a nearby city that would benefit from variable-rate funding for its short-term asset portfolio. The opportunities to borrow funds for the two parties is as follows:

­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­_________________Variable Rate_____________Fixed Rate

ISWAP (firm)                LIBOR + 1%                           14%

USWAP (bank)            LIBOR + 0.5%              12%  ____________

From this information, it is clear that ISWAP pays a 2 percent premium for fixed-rate funds but only a 0.5 percent premium for variable-rate funds.

Assume that an intermediary is contracted to handle the details of the swap. ISWAP takes out a variable-rate loan at LIBOR + 1 percent but swaps this loan's payments with USWAP, who issues seven-year notes at 12 percent. ISWAP pays USWAPs interest bill plus 0.1 percent fee to intermediating bank. USWAP pays the LIBOR component of ISWAP's variable-rate loan and leaves the fixed 1 percent to be paid by ISWAP.

First, draw a diagram that shows all parties, including arrows showing the flow of funds in the swap, as well as the interest rates paid by ISWAP and USWAP through the intermediary. Second, make a table showing ISWAP's costs, ISWAPS's savings from the swap, the intermediary's fees, and the receipts and payments between ISWAP and USWAP.