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I’ve got the following problem to solve: enter image description here

The solution proposed by the textbook uses comparative advantage and says that A has comparative advantage in the fixed-rate market while B has comparative advantage in floating-rate market. I don’t really understand it since it is clear from the table that A can borrow at lower rates than B in both markets so A has absolute advantage. Can anyone explain it and explain how to solve the problem?

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Consider a scenario where

  1. A takes out a 5% fixed rate loan, and a swap where they receive 5% fixed and pay (LIBOR + X%) floating
  2. B takes out a (LIBOR + 0.6%) floating rate loan, and a swap where they pay 5% fixed and receive (LIBOR + X%) floating*

The improvement that A would see on their floating rate loan is 0.1% - X% and the improvement that B sees on their fixed rate loan is 0.8% + X%. If X = -0.35% the both parties have the same improvement vs the scenario where they don't do a swap. However we also need to account for 0.1% profit margin for the bank, so we adjust the rates to -0.3% and -0.4% which means the final arrangement is

  1. A takes out a 5% fixed rate loan, and a swap where they receive 5.3% fixed and pay LIBOR (resulting in a floating rate at LIBOR - 0.3%)
  2. B takes out a (LIBOR + 0.6%) floating rate loan, and a swap where they pay 5.4% fixed and receive LIBOR (resulting in a fixed rate at 6%)

Now both parties improved the rate on their loans by 0.4%, and the bank that arranged the swap makes 0.1%.

*I added a spread to the floating leg to make the math more straightforward, in reality you would simply adjust the rate on the fixed leg.

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  • $\begingroup$ Thank you very much! Can you also explain why B has comparative advantage in the floating-rate market? $\endgroup$ – Nick Oct 13 '20 at 18:02
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    $\begingroup$ It's simply that the credit spread (i.e. the rate that B pays minus the rate that A pays) is 1.4% in the fixed rate market but only 0.5% in the floating rate market. If they were equal, there would be no comparative advantage. If the fixed rate spread was lower, B would have a comparative advantage in the fixed rate market. Note that the size of the comparative advantage is 0.9% which is the total saving available. In this example 0.4% goes to A, 0.4% goes to B and 0.1% goes to the bank who arranged the swap. $\endgroup$ – Chris Taylor Oct 13 '20 at 19:10

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