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What is the risk associated with such swap arrangements

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Reference no: EM133197241

Consider two hypothetical companies A and B. Assume that company A wants to raise debt and pay a floating interest rate, which is usually done to finance short-term receivables and credit that earns a short-term interest rate. Company B, conversely, wants long-term fixed rate financing, perhaps to finance the purchase of machinery and equipment. The cost to each party of accessing either the fixed-rate or the floating rate market for a new five-year debt issue is as follows: 

 

Company A

Company B

Floating

LIBOR  

LIBOR + 0.5%

Fixed

8.5%

10%

Is it possible for the two companies to reduce their financing costs through interest rate swaps? Why or why not? If your answer is yes, what will be the total savings in financing costs for the two companies? What is the risk associated with such swap arrangements?

Design a swap that will net a bank, acting as intermediary, 0.1% per annum and will appear equally attractive to A and B.

Reference no: EM133197241

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