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On page 420 of Bailey's "The Economics of Financial Markets" textbook there is an example:

"For example, suppose that [in a plain vanilla interest rate swap] the company agrees to pay 9.25 per cent and receive LIBOR + 40b.p."

Isn't this equivalent to a swap where the company pays 8.85 per cent and receive LIBOR? What are the advantages of expressing the contract this way?

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  • $\begingroup$ It is just to make the numbers come out nicely in this made up academic example. (I don't have access to this page of the book, but probably 40bp or 9.25% occurs elsewhere in the example and leads to a magical cancellation). In real life a low credit rating firm is not going to swap loans with a high credit rating one, (and may not even be able to engage in IRS at all if it is not AAA) so forget it, it is just not realistic to use IRS this way. $\endgroup$ – Alex C May 6 '18 at 16:47
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There might be a number of reasons swaps are structured this way. Firstly, you only make the assumption of 40bps on both legs (fixed and floating) being equivalent if the payment frequency is the same, and the day count fraction too. If it isn't, say one is Annual-Fixed and the other Quarterly-Floating then then it will be different. In US and EUR for example both frequency and DCF are normally different.

Corporates and asset managers often swap their actual cashflows, so if a corporate has issued a floating rate loan at LIBOR+40 and it wants to convert it to fixed then it is natural to swap the precise floating leg so there are no mismatches in cashflows. This is just operationally efficient.

Equivalently an investor who has purchased a bond and receives a fixed coupon of say 3% may indeed swap it with a 3% fixed rate to return LIBOR + X bps.

Benchmarking as LIBOR + X is often a very common measure and more meaningful to some entities than others, where the fixed rates may be less of a concern.

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