Comparative Advantage and Gains from an Interest Rate Swap
Summary
The document explains how two borrowers with different fixed and floating borrowing spreads can create gains by borrowing in the markets where each has a relative advantage, then exchanging interest payments through a swap. One firm has lower borrowing costs in both markets, but its advantage is larger in fixed-rate funding. The other firm prefers fixed-rate exposure, while the first prefers floating-rate exposure.
The total potential gain is the difference between the firms’ fixed-rate spread gap and floating-rate spread gap. In the example, that difference is half a percentage point, which the accepted answer treats as the combined savings available to divide between them. It illustrates an equal split and outlines cash flows that deliver each firm its preferred exposure. The result assumes the stated borrowing rates are available and the swap can be arranged on suitable terms; it does not address counterparty risk, collateral, transaction costs, or how the parties negotiate their share of the gains.
Key ideas
- Comparative advantage depends on the difference between each borrower’s relative funding costs across fixed and floating markets.
- The total swap gain equals the fixed-rate borrowing spread gap minus the floating-rate spread gap.
- Borrowing in the market with the stronger relative advantage can create room for both parties to benefit through a swap.
- The gains can be divided by agreement, while the illustrated equal split is only one allocation.
Tags
Full text
# Swap contract comparative advantage
# Swap contract comparative advantage
> Corporation $A$ has an excellent credit rating and can borrow at a fixed rate of $5\%$ or a floating rate of LIBOR + $1\%$. Corporation $B$ has a somewhat less excellent credit rating and can borrow at a fixed rate of $7\%$ or a floating rate of LIBOR + $2.5\%$. Both firms wish to borrow $10,000,000$ for $3$ years and $A$ would rather borrow at a floating rate and $B$ would prefer to borrow at a fixed rate. What are the comparative-advantages and total gains that $A$ and $B$ could attain if they engaged in a swap contract
The solution to this from what I have been provided is $$\Delta \ \text{fixed}(B-A) - \Delta \ \text{float} (B-A) = (7-5) - ((L+2.5) - (L+1)) = .5$$
I do not understand this at all, if anyone could give me some insight and provide a detailed solution I would greatly appreciate it.
## Answer by MH.Q (score 5, accepted)
https://quant.stackexchange.com/a/33845
It is actually rather simple.
Lets start with the fixed rate market. A can borrow at 5% while B can borrow at 7%. Simply said, A has a comparative advantage of 2% in the fixed rate market.
In the floating rate market, A borrows at LIBOR + 1% while B borrows at LIBOR + 2.5%. From here, I'm guessing you already know that A has the comparative advantage as well of 1.5%.
Now by this 2 factors, we can automatically assume that A will borrow in the Fixed rate market due to higher comparative advantage while B will borrow from the floating rate market to not lose out so much.
The question you are asked is simply asking what is the total gains both A and B would get if they were to be engaged in a swap. The answer is simply the difference in the credit spread between the two markets, 2% - 1.5% = 0.5%
Note that 0.5% is the TOTAL gains from the swap. If they were to spread the gains equally, it would mean A would enjoy 0.25% cost savings in the floating rate market while B would also enjoy 0.25% cost savings in the fixed rate market using the swap.
The swap can easily be conducted using the following steps:
1) A borrows 10,000,000 from fixed market at 5%
2) B will pay A monthly fixed interest payments of 6.75%
Note that the net effect here is that B essentially pays fixed payment of 0.25% less than he would have without the swap. A gains a total of 1.75% from this cash flow.
3) B borrows 10,000,000 from the floating market at LIBOR + 2.5%
4) A pays B monthly floating interest payments of LIBOR + 2.5%
From this cash flow, B has a net effect of 0 in the floating rate payments. A will then use the 1.75% gains in the previous cash flow to offset the cash flow here, enabling A to pay only LIBOR + 0.75% monthly. A essentially pays 0.25% less than he would have without the swap as well.
The swap thus allows both parties to gain from the credit spread of 0.5% equally.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.