Set out the comparative advantage argument behind interest rate swaps and evaluate some objections to it.
The idea
The comparative advantage argument says two firms can both borrow more cheaply by swapping if the quality spread between them differs across markets. Suppose firm A is better in both the fixed and floating markets, but its advantage is larger in the fixed market. A should borrow fixed, B should borrow floating, and they swap. The total annual gain is the difference between the two spreads. Gain = (fixed spread) − (floating spread). A spread here is how much more B pays than A in that market. The gain is shared as agreed, less any dealer fee. No gain exists if each firm wants to borrow in the market where its relative advantage lies. The main objection is that the floating-rate spread is reset as credit quality changes, whereas the fixed-rate spread is locked in for the term. So part of the apparent gain compensates for lenders repricing risk. Check who wants what before calculating any gain.
Formulas
Total gain from a comparative advantage swap
total gain = fixed-rate gap − floating-rate gap
- fixed-rate gap
- the difference between the two firms' fixed borrowing rates
- floating-rate gap
- the difference between their floating spreads
Only when each firm wants funding in the market where it lacks the advantage. Any dealer fee comes out of it, and part of it reflects floating spreads being reset.
A practice question
Firm A can borrow fixed at 4.5% and floating at the reference rate + 0.2%. Firm B can borrow fixed at 6.0% and floating at the reference rate + 0.9%. In which market does Firm A have a comparative advantage?
- The fixed-rate market, where its advantage is 1.5% rather than 0.7%. - correct
- Neither market, because Firm B is the weaker borrower in both.Why not: A weaker borrower in both markets does not remove the comparative advantage of the stronger one.
- The floating-rate market, where its spread is smallest in absolute terms.Why not: A comparative advantage is judged by the size of the gap versus the other firm, not by the lowest absolute spread.
- Both markets equally, because its rates are lower in each.Why not: An absolute advantage in both markets does not make comparative advantage equal.
A pays 1.5% less than B in the fixed market and 0.7% less in the floating market. A's advantage is larger in fixed, so it has the comparative advantage there.
A harder one
Firm A (fixed 4.5%, floating reference + 0.2%) wants floating debt and Firm B (fixed 6.0%, floating reference + 0.9%) wants fixed debt. They swap directly with no intermediary and share the total gain equally. What is Firm A's net floating cost?
- Reference rate + 0.2%Why not: Does not apply any of the gain; this is its direct borrowing cost.
- Reference rate - 0.2% - correct
- Reference rate + 0.6%Why not: Adds its share of the gain to its cost instead of subtracting it.
- Reference rate - 0.6%Why not: Gives Firm A the whole 0.8% gain instead of sharing it equally.
Total gain 0.8%, so each firm saves 0.4%. A's direct floating cost is reference + 0.2%, so after the swap it pays reference + 0.2% - 0.4% = reference - 0.2%.
The hardest tier
Firm A can borrow fixed at 4.5% and floating at the reference rate + 0.2%; Firm B can borrow fixed at 6.0% and floating at the reference rate + 0.9%. Firm A needs fixed-rate funding and Firm B needs floating-rate funding. What total saving does a swap deliver?
- 0.8%, the difference between the fixed and floating spread gaps.Why not: Calculates the gain ignoring who wants which funding; here each firm already borrows where it has its comparative advantage.
- 1.5%, the fixed-rate gap between the two firms.Why not: Uses only the fixed-rate gap, which is not the swap gain.
- 0.0%, because each firm should simply borrow in the market it wants. - correct
- 0.7%, the floating-rate gap between the two firms.Why not: Uses only the floating-rate gap, which is not the swap gain.
A wants fixed and has its comparative advantage in fixed; B wants floating and is relatively better in floating. Each borrows directly where it wants to, so a swap has no gain to share.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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