Buffet Inc wishes to raise capital under a floating interest rate, as it would like to be able to
take advantage of any fall in interest rates. It can borrow at a fixed rate of 4% or at a floating
(LIBOR – 1%) i.e. LIBOR rate minus 100 basis points. Gates Inc also wishes to raise external
finance, preferably by issuing a fixed rate debt because they want certainty about their future
interest payments, but can only borrow at 7% fixed or LIBOR + 1% floating. Assume both
companies want to borrow the same amount in the same currency and there are no transactions
costs (except the swap dealer’s fees).
a) Develop an interest rate swap in which both Buffett Inc and Gates Inc have equal cost
savings in their borrowing costs. Provide standard illustration (diagram) of payments in the
swap, including the net payments for each counterparty to the swap. b) Introduce a swap dealer to the swap deal and illustrate (using the standard diagram) how he
could earn a total of 0.1% spread (equally split across Buffett and Gates, the two swap
counterparties)