Question

The comparative advantage argument is often used to explain the benefits of swaps. In the Excel file, you will find the cost of fixed rate and floating rate for two companies that do not have the same credit quality. AAA company wants to borrow at floating rate, while the BBB company wants to borrow at fixed rates. a) Calculate the total gain (in terms of interest rates) that the two companies can achieve by entering into a swap between them. b) Assuming that the gain is divided equally between the two companies, provide new financing costs for AAA (the example in your lecture notes on swaps should help) c) Assuming that the gain is divided equally between the two companies, provide new funding costs for BBB (for help, use the example from your lecture notes on swaps). d) Suppose the fixed rate for the BBB has been 7.4% instead of 8% (all other rates are unchanged). Would it have been possible to gain by entering into a swap between AAA and BBB? Why? e) Explain briefly why the comparative advantage argument is misleading.

Answer 1

Let bankers' acceptance rate be R% (floating). The situation is as below :

	Fixed Rate	Floating Rate
AAA	7%	R+0.1%
BBB	8%	R+0.5%
Difference	1%	0.40%

a) AAA has absolute advantage in both fixed rate and floating rate. Howevr, AAA has comparative advantage in fixed rate and BBB has comparative advantage in floating rate (as the difference between Fixed rate is more than floating rate) . Since AAA wants to borrow in floating rate and BBB wants to borrow in fixed rate , they can gain by borrowing in fixed and floating rates respectively and entering into a swap to get borrowing of their choice

The total gain is difference between the advantages (last row) = 1% -0.4%

=0.6%

The companies's total gain after swap is 0.6%

b) If the gain is divided equally, AAA would gain 0.3% and BBB would gain 0.3% ,

So after the swap, AAA borrows in fixed rate at 7%,

AAA pays foating rate of R-0.2% to BBB

AAA receivedfixed rate of 7% from BBB

net borrowing cost of AAA in floating rate would be R-0.2%(paid to BBB) + 7% (paid for borrowing) - 7% (received from BBB)   = R-0.2% (0.2% less than bankers acceptance rate)

   = - 0.2% (spread on top of bankers acceptance rate) (new cost of financing)

c)

Floating rate paid on top of BA rate = 0.5%

Fixed rate paid from BBB to AAA = 7%

Floating rate received by BBB from AAA on top of BA rate = -0.2%

S0o, net borrowing cost of BBB in fixed rate would be = 0.5% (floating rate paid on top of BA rate) + 7% (fixed rate paid to AAA) - (-0.2%) received from AAA = 7.7% (new cost of financing)

d) If the fixed rate of borrowing for BBB were 7.4%, we have

	Fixed Rate	Floating Rate
AAA	7.0%	R+0.1%
BBB	7.4%	R+0.5%
Difference	0.4%	0.40%

The net gain by swap = 0.4% -0.4% =0

Hence,it would not be possible to have a gain by entering into a swap as the comparative advantage of AAA over BBB in fixed rate market is lost because of reduced rate of borrowing of BBB in fixed rate.