Compararative Advantage

The Theory of Comparative Advantage =

Comparative Advantage:

When we need an answer to the question why interest rate swaps benefit both parties, the response we are most likely to meet from both market participants is that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied.

The AAA company raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. This argument is an attractive one because of its relative simplicity and because it is fully consistent with data provided by the swap market itself.

However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out: The United States has a comparative advantage in wheat because the United States has wheat producing acreage not available in Japan. If land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage would disappear.

The international capital markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and this rationale for the creation of the swap transactions would be eliminated over time leading to the disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued and expanding existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some force -- not withstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole explanation for the value created by swap transactions. The source of that value may lie in part in at least two other areas.

Reference Pages

Profit from Interest Rate Swaps

Pricing Interest Rate Swaps

Foreign Currency Rates