Explanation:
Compute the available gain from comparative advantage:
The swap gain is the difference between the two spreads:
The investment bank requires a 20 bps fee, leaving 20 bps to be shared between the two counterparties. That means each company can receive 10 bps of benefit.
So the swap is advisable and profitable for all three parties, and the correct answer is C.
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Q-174.3. An intermediacy (investment bank) considers entering into two swap transactions, one with each of Company A and Company B. Company A is the better credit risk and can borrow at 5.0% in the fixed market and LIBOR + 30 basis points in the floating market. Company B can borrow at 5.8% in the fixed market and LIBOR + 70 basis points in the floating market. Company A wants to borrow at floating rates; Company B wants to borrow at fixed rates. The intermediacy will only enter into the swaps if it can earn a fee of 20 basis points per annum. Is the swap advisable and profitable to all three counterparties?
A
No, because the total gain possible for all three parties is negative 40 basis points (-40 bps), so the swap is not advisable
B
No, because the total gain possible for all three parties is negative 90 basis points (-40 bps), so the swap is not advisable
C
Yes, because the total gain for all three parties is 40 basis points, which allows for +10 bps to each company after deducting the intermediary fee
D
Yes, because the total gain for all three parties is 60 basis points, which allows for +20 bps to each company after deducting the intermediary fee