Suppose Bank A is willing to allow you to enter into either side of a 3-year swa

ID: 2792929 • Letter: S

Question

Suppose Bank A is willing to allow you to enter into either side of a 3-year swap agreement

where LIBOR is exchanged for a fixed 8% interest. At the same time, Bank B is willing to lend

you money for 3-years and charge you LIBOR+.5% each year in interest. Alternatively, Bank B

is willing to allow you to deposit your money in the bank and earn an annual interest payment

each year of LIBOR-.5%. Finally, Bank C is willing to lend you money (let you deposit your

money) and pay (earn) a fixed 7% interest for the next 3-years. Is there an arbitrage opportunity

here? What is it

Options available:

Pay Libor Receive 8%

Borrow from Bank B and Pay Bank B LIBOR+0.5%

Lend Bank B and receive from Bank B LIBOR-0.5%

Borrow from Bank C and recieve from Bank C 7%

Lend Bank C and receive from Bank C 7%

Hence, we should

1. Lend Bank B @LIBOR-0.5% & Borrow from Bank C @7%

2. Receive 8% from swap and pay LIBOR to swap..

Net recived=LIBOR-0.5%-7%+8%-LIBOR=0.5%

or net received=0.5%

Thus this is arbitrage

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