Question

Explain using examples how the use of swap contracts allows for comparative advantage

Explain using examples how the use of swap contracts allows for comparative advantage

Answer 1

Swap contracts:

A swap contract refers to the lawful agreement where two parties agree to exchange a series of cash flows in the defined future period. A random variable is attached to the contract such as interest rate, exchange rate, and share price.

Use of swap contracts for the comparative advantage:

An interest swap is a swap contract between two parties who trade at the fixed-interest rate and variable-interest-rate respectively. One party receives the payment as per the variable interest rate and another party limits its risk of lower interest rates.

Company A and Company B may enter into an interest swap contract for 1 million. Where, Company A may borrow a bond with a fixed rate of 20% or the 3 months LIBOR + 0.70%. Company B can borrow a bond with a fixed rate of 22.5% or the six-month LIBOR+2%.

A profitable swap can be done when Company A borrows at 20% and Company B at LIBOR + 2%. Company A agrees to pay LIBOR (not + 2% and receives interest at a fixed rate of 19.6% (20-2%).

Company A’s actual borrowing is at LIBOR+0.4% or 0.30 (0.70-0.40) less than the floating interest. Company B’s actual borrowing will be at a fixed rate of 21.4% (19.4% + 2%). It is lower than the fixed rate of 22.5% by 1.1%.

Thus, both companies have a comparative advantage.