Question

Swap contract - from a banker's perspective Suppose Firm A can issue 7-years bonds in Germany at the fixed rate of 3% and in the U.S. at 8%. Suppose Firm B can issue 7-years bonds at the fixed rate of 5% in Germany and at 9% in the United States. (a) Which firm has a comparative advantage in the U.S. capital market? (b) How would you advise both firms so that they take advantage of each other's comparative advantage in the German and U.S. capital markets? (c) How much could be saved in borrowing costs by both firms? (d) What could cause the relative comparative advantages in international credit markets?

Answer 1

Here , Firm A is better than Firm B as A can issue bonds at a cheaper rate than B in both US and Germany

However since A's advantage over B in Germany is 2% and

A's advantage over B in US is 1%

a) A has comparative advantage over B in Germany and B has comparative Advantage over A in US markets

b) Both firms can take benefit of comparative advantage by Swap if they want to take loan in the market where they don't have comparative advantage. For example, if A wants to issue bonds in US and B wants to issue bonds in Germany. In these markets, both don't have comparative advantage

In this case, A can issue bonds in Germany and B in USA and can exchange cashflows with each other periodically in a pre-determined manner.

c) The total savings in borrowing cost by using a Swap would be the difference in the advantage ie. (2%-1% = 1%) . So, total savings in borrowing cost by using a Swap is 1%.

d) A better firm enjoys cheaper borrowing rates and a weaker firm has to pay higher borrowing cost or a premium over the stronger firm. However, this premium may not remain constant in different countries because of country parameters like inflation, interest rates, etc. Also, the weaker firm may be comparatively stronger than the strong firm in a particular country. These factors lead to relative comparative advantages in International credit markets