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CA Final · Advanced Financial Management · Derivatives Analysis and Valuation

Two firms can borrow as follows. Aarav Steel Ltd: fixed 10%, floating MIBOR + 1%. Bhavya Foods Ltd: fixed 12%, floating MIBOR + 2%. They enter an interest rate swap that splits the total interest saving equally. Aarav borrows in the market where it has the comparative advantage and swaps into floating. After the swap, what is Aarav's effective floating-rate cost?

Aarav's effective floating cost is MIBOR + 0.5%. The quality spread differential is 1% (2% fixed gap minus 1% floating gap). Split equally, each firm saves 0.5%, which reduces Aarav's normal floating cost of MIBOR + 1% to MIBOR + 0.5%.

  1. AMIBOR + 1%
  2. BMIBOR + 0.5%Correct
  3. CMIBOR + 0.75%
  4. DMIBOR

Explanation

The fixed-rate gap is 12% − 10% = 2%. The floating-rate gap is 2% − 1% = 1%. The quality spread differential is 2% − 1% = 1%, so each firm gains 0.5%. Aarav's direct floating cost is MIBOR + 1%, so its swapped cost is MIBOR + 1% − 0.5% = MIBOR + 0.5%. MIBOR + 1% ignores the gain altogether.

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