Does anybody know how this concept works? The explanation in Schweser sucks (AIMS 28.5 & 28.10).
If you have two companies that both can borrow fixed or floating, but have different spreads doing so, they can (on paper) both save money by doing a swap. Here’s an example: Company X can borrow at 6 % fixed or L+150 floating Company Y can borrow at 7 % fixed or L+100 floating There is an uneven spread between the two fixed rates (7 % vs 6 % = % 1) and the floating rates (150 vs 100 = 50 bp), so there is comparative advantage between the two companies (one is a better floating borrower, the other a better fixed borrower). They can both save 25 bp (half of the difference between the two spreads) by doing a swap: X borrows at 6 % (even though it’d like to REALLY borrow floating, but it gets a better deal borrowing fixed) Y borrows at Libor + 100 (even though it’d like to borrow fixed, but it gets a better deal borrowing floating) Now they do a swap and with the swap X will end up borrowing floating at L+125 and Y will borrow fixed at 6.75 %, each 25 bp better than without the swap.
Thanks for the help. Schweser wasn’t very helpful…though there was some decent info on the Bionic Turtle.
I like Klarsolo’s example, though there’s one significant difference (in my opinion) between Schweser’s example and Klarsolo’s. In Klarsolo’s example, X has an absolute advantage in borrowing fixed (6% vs. 7%) and a comparative advantage in borrowing floating (100bp spread vs. -50bp spread). Y has a absolute advantage in borrowing fixed (LIBOR + 100bp vs. LIBOR + 150bp) and a comparative advantage in borrowing floating (50bp spread vs. -100bp spread). I use a negative spread for analyzing comparative advantage because you have to evaluate the results relative to each other, not just the absolute spread. It’s sort of like an NPV analysis - in order to ascertain which project you would take, you calculate all the NPV’s and take the one with the biggest NPV, subject to your resources available to carry out the project, right? So, if you have projects with NPV’s of +50, +20, +2, -12 and -100, you’d almost certainly try to start with the +50 and work your way down. Same thing with comparative advantage - for two companies with two sources of borrowing, even if one company can borrow fixed and floating cheaper than the other (Schweser’s example), unless the spread is exactly the same, the company will have a comparative advantage in borrowing either fixed or floating, but not both. So, to put it in context of Schweser’s example, Company Y has an absolute advantage in borrowing both fixed and floating (5% vs. 6.5% and LIBOR + 10bp vs. LIBOR + 100bp), but a comparative advantage in borrowing fixed only (150bp spread vs. 90bp spread). It’s better for Company Y to borrow at fixed only and let Company X borrow floating, even if it’s more expensive for Company X to borrow (assume there’s some kind of limitation on borrowing amounts). Once they trade off, the comparative advantage is realized with that 60bp savings.