Answer: Company B pays 5.6% fixed and receives (floating) LIBOR (swap only)

Company A has the comparative advantage in the floating-rate market (its floating-rate borrowing cost is 1.0% lower than B's, versus only 2.0% lower in the fixed-rate market). The total gain from swapping is therefore: - Fixed-rate spread advantage: 8.0% - 6.0% = 2.0% - Floating-rate spread advantage: (LIBOR + 2.0%) - (LIBOR + 1.0%) = 1.0% - Net gain from swapping = 2.0% - 1.0% = 1.0% - Less intermediary fee = 0.2% - Remaining gain = 0.8% - Split equally = 0.4% each Company B wants fixed-rate funding. If B borrows at floating LIBOR + 2.0% and enters a swap where it pays fixed and receives floating, its swap fixed payment must be 5.6% so that its all-in fixed cost is: - (LIBOR + 2.0%) + 5.6% - LIBOR = 7.6% That gives B a 0.4% benefit versus borrowing fixed directly at 8.0%. Therefore, the correct swap trade for Company B is: **B pays 5.6% fixed and receives LIBOR.**

Author: Manit Arora