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The Comparative Advantage Argument

  

  • Take the example of two firms X and Y where:
  • X wants to borrow floating
  • Y wants to borrow fixed

Company

Fixed Borrowing

Floating Borrowing

X

5%

LIBOR

Y

7%

LIBOR + 100bps

 

  • Table tells us that X can borrow fixed at 5% and Y can borrow fixed at 7%
  • Also X can borrow floating at LIBOR and Y can borrow floating at (LIBOR + 100bps)
  • This implies that X has absolute advantage in borrowing over Y
  • The point to note here is that the difference in fixed borrowing rates for X and Y (is not the same for the floating borrowing rates)
  • Combined benefit to both X and Y by using swap is which is 100 bps for X and Y
  • To reduce the borrowing rates X and Y enter into a swap shown below through the intermediary which is usually an Investment Bank (IB)
  • Assuming zero transaction charges for IB, X borrows at 5% and lends that money at 5.5% to Y through an investment banker
  • Similarly Y borrows at LIBOR + 100bps and lends to X at LIBOR
  • Therefore the net borrowing rate for X becomes (LIBOR – 50bps) which is lower than the original rate at of LIBOR
  • Similarly the net borrowing rate Y becomes 6.5% which is 50bps less than the original rate of 7%

 


Question – Comparative Advantage

  • Following are the rates at which company ABC and XYZ can borrow from the market
 

Fixed Rate

Floating Rate

ABC

11%

LIBOR + 1%

XYZ

10%

LIBOR + 3%

 

  • How can they benefit from Interest Rate SWAP?

 

Solution – Comparative Advantage

 

  • XYZ and ABC both benefit by 50bps while the IB makes 200bps profit





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