Using Comparative Advantage to Structure an Interest Rate Swap
Summary
The document illustrates how borrowers with different relative advantages in fixed and floating rate markets can use an interest rate swap to improve their borrowing costs. Although one party has lower borrowing rates in both markets, the comparison of their rate advantages determines how the potential swap benefit can be divided. The example has one party borrow at a fixed rate and exchange that obligation for floating payments, while the other borrows floating and swaps into fixed payments.
The calculation first allocates the gross improvement between the borrowers, then reserves a portion for the arranging bank. In the stated example, both borrowers receive the same net rate improvement after the bank’s margin. This is an illustrative rate arithmetic exercise rather than evidence about actual market pricing. Its result depends on the quoted borrowing spreads, the chosen split of gains, and the assumption that the swap terms are available as described.
Key ideas
- Absolute advantage in both borrowing markets does not determine which borrower has comparative advantage in each market.
- The potential swap benefit comes from differences in relative fixed and floating borrowing spreads.
- A fixed borrower and a floating borrower can exchange exposures through a swap to reduce borrowing costs.
- The example allocates gains between the two borrowers and an arranging bank.
- The numerical outcome depends on the rates and margin assumptions in the example.
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Full text
# Comparative advantage for swaps # Comparative advantage for swaps I’ve got the following problem to solve: The solution proposed by the textbook uses comparative advantage and says that A has comparative advantage in the fixed-rate market while B has comparative advantage in floating-rate market. I don’t really understand it since it is clear from the table that A can borrow at lower rates than B in both markets so A has absolute advantage. Can anyone explain it and explain how to solve the problem? ## Answer by Chris Taylor (score 3, accepted) https://quant.stackexchange.com/a/58642 Consider a scenario where - A takes out a 5% fixed rate loan, and a swap where they receive 5% fixed and pay (LIBOR + X%) floating - B takes out a (LIBOR + 0.6%) floating rate loan, and a swap where they pay 5% fixed and receive (LIBOR + X%) floating* The improvement that A would see on their floating rate loan is 0.1% - X% and the improvement that B sees on their fixed rate loan is 0.8% + X%. If X = -0.35% the both parties have the same improvement vs the scenario where they don't do a swap. However we also need to account for 0.1% profit margin for the bank, so we adjust the rates to -0.3% and -0.4% which means the final arrangement is - A takes out a 5% fixed rate loan, and a swap where they receive 5.3% fixed and pay LIBOR (resulting in a floating rate at LIBOR - 0.3%) - B takes out a (LIBOR + 0.6%) floating rate loan, and a swap where they pay 5.4% fixed and receive LIBOR (resulting in a fixed rate at 6%) Now both parties improved the rate on their loans by 0.4%, and the bank that arranged the swap makes 0.1%. *I added a spread to the floating leg to make the math more straightforward, in reality you would simply adjust the rate on the fixed leg.
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