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Answer: Pay fixed EUR at 4.75% in exchange for receiving floating USD at LIBOR + 2.0%
Company A has the stronger comparative advantage in EUR fixed-rate borrowing, while Company B has the comparative advantage in USD floating-rate borrowing. Since B wants fixed EUR exposure, B should: 1. borrow in its comparative-advantage market: **USD floating at LIBOR + 2.0%** 2. enter a swap that converts that into **fixed EUR** 3. share the 50 bp intermediary spread equally Thus B will: - **pay fixed EUR at 4.75%** - **receive floating USD at LIBOR + 2.0%** So the correct choice is **D**.
Author: Manit Arora
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Question 1.2. Currency swap with intermediary spread
Company A is able to borrow either: US dollars (USD) at a floating rate of LIBOR + 1.0% or euros (EUR) at a fixed rate of 3.0%. Riskier Company B can borrow either: US dollars (USD) at a floating rate of LIBOR + 2.0% or euros (EUR) at a fixed rate of 5.0%. The interest rates are already adjusted for the differential impact of taxes. Company A prefers to borrow in floating USD dollars. Company B prefers to borrow in fixed EUR euros. A financial institution will intermediate a currency swap in exchange for a 50-basis-point spread. Assume the swap is equally attractive to both companies. What swap does company B enter into with the intermediary (the swap only, not the underlying borrowing)?
A
Pay floating LIBOR at LIBOR + 1.0% in exchange for receiving fixed EUR at 3.0%
B
Pay floating LIBOR at LIBOR + 2.0% in exchange for receiving fixed EUR at 4.75%
C
Pay fixed EUR at 3.0% in exchange for receiving floating USD at LIBOR + 1.0%
D
Pay fixed EUR at 4.75% in exchange for receiving floating USD at LIBOR + 2.0%
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