Swaps and The Law of Comparative Advantage – How to do the comparative advantage swap calculation.

In todays video we learn about how Swap participants benefit from the law of comparative advantage.

Going to learn about comparative advantage and swaps. ok, youtube today with. it’s an idea that we cover in my class on financial derivatives and it’s with this problem i’ve seen online people posting on cfa internet forums today’s video. in economics, the law of should specialize in producing the goods that they are best or most efficient at both countries better off. david

Ricardo’s vital contribution to economic that even if one country is more efficient in the production of all goods countries, all countries will still gain or still benefit, by trading with each link to to the law of comparative advantage in economics below if international trade even when one country’s workers are more efficient at for the comparative advantage problem

In swaps, we take that idea from it’s easy to understand how if one company is able to get a better deal in company is in the equal and opposite situation it might make sense for these access to the capital markets than all others it might still make sense for argument comes in and so this is the problem that that you’re often given to companies company x is able to borrow

At three and a half percent fixed or live and now sometimes people get confused when they see libor – the reason a lend to each other at and of course if your company is a better credit than a floating now company y is able to borrow it either four and a half percent fixed able to borrow at a better rate in both the fixed and the floating rate markets which company x would

Benefit from an interest rate swap well let’s look at it analyze how much better or a company x can borrow out in either market than a 0.6% better rate on a floating basis company x has a comparative advantage in greater they have an absolute advantage they’re better in both markets but they to look at the magnitude of the rate differences in each market and note them percent

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Fixed and four and a half percent fixed is one percent often means the same thing one percent. then let’s look at the difference between you’re not calculating that correctly it’s because you’re not paying attention 0.4 percent so the difference between that is 0.6 of a percent or 60 basis fixed they can enter into a swap agreement with each other and improve borrow floating

And company y prefers to borrow fixed if it’s the other way floating advantage of 0.6 percent is 0.4 percent so we’re just taking 1% minus that this can be split evenly between the two counterparties now most of the benefit evenly like this but of course in the real world it can be split it’s being split evenly so what we’ve done there a step number two is just to question

The two companies are splitting this evenly between themselves that swap diagram if you don’t know how to draw a swap diagram do watch my last we’re gonna draw the swap diagram and we’re gonna show each company borrowing they’re going to do is they’re going to borrow at the rate in which they have a borrowing into floating or they’re floating borrowing into fixed we’re at

Which each of our borrowers is 0.2 percent better off you only actually other side for the purposes of this video i’m gonna do the calculation on exercise our company wise side but i shall see at the end we’ll get to the the company x side of the diagram to begin with so company eggs will be have a comparative advantage in that’s the fixed rate that they can get from to

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Swap into floating we know their eventual borrowing rate will be libor able to borrow out in the market right now is libor minus 0.2 percent but we was libor minus 0.2 and we calculated in step two that they would be zero point difference evenly between the two companies sum to zero point four percent and advantage so if they’re going to be borrowing at libor minus 0.4 and

We put percent more in the fixed leg of the swap that they’re receiving from company percent that they’re paying out in the fixed-rate market right because we have bringing in an additional point four in order to be that much better off so we paying out and that gives us three point nine percent now three point nine percent is going out that means zero point four percent

Is left over as an they’re effectively borrowing at libor minus 0.4 percent which is of course rate market where they would have gotten libor – 0.2 percent company why is also libor coming in on the swap and libor plus point for going out that means that paying three point nine percent out to x as the fixed rate in the swap and so initially they were able to borrow at four

Point five percent so by borrowing percent fixed which is zero point two percent better off than they would have is solved now for the purposes of this video we’ll resolve the problem but this you that we can solve it from either side of the equation so to resolve the you want to see those calculations again just rewind the video and watch from before and we have decided

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To split it evenly between them just like before and 0.4 percent so so far everything is the same as we did it before we then draw comparative advantage in so that is once again just like before and so they’re they’ll swap into the style of borrowing that they actually wanted to borrow so they had the comparative advantage and then they’re swapping into fixed and we rate

That they would have naturally gotten and that means that they have to have to end up with a fixed borrowing cost of 4.3% now they have libor coming at libor plus 0.4% is going out and so point four more is going out than it’s we need to subtract 0.4 percent from four point three percent and thus the that three point nine percent is going out on the swap and zero point four

Than they would have done without the swap so that’s all we have to do to type of problem as you can see there’s no fancy mathematics going on it’s just and do the calculation alongside with a pen and paper one additional there who charges a fee that’s simply enough dealt with if the difference broker was taking out a fee of will say 0.1% on the swap we would just take the

Percent that can then be split evenly between the two making them 15 bits that that’s all you need to do if there’s a brokerage cost coming out let me know in questions that you ask in there if you found the video useful please hit the great day and see you soon best of luck in your exams bye

Transcribed from video
Swaps and The Law of Comparative Advantage – How to do the comparative advantage swap calculation. By Patrick Boyle

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