Economic Motives for Swaps – Risk Reduction & Cost Savings

1. Introduction

Companies don't sign complex swap agreements for fun. They do it for two hardcore economic reasons: To lower their Cost of Capital and To manage Risk. The mathematical logic used to prove this is called the Quality Spread Differential (QSD).

2. The Motives

A. Reducing Borrowing Costs (Arbitrage)

• Concept: Some markets are inefficient. A company might be rated "AAA" in USA but "BBB" in Europe.
• Strategy: It borrows in the USA (where it is loved) and swaps it for Euros.
• Result: It gets Euros cheaper than if it had gone directly to a European bank.

B. Risk Management (Hedging)

• Concept: A company with fixed income (like a Bond) but floating liabilities (LIBOR loan) faces mismatch risk.
• Strategy: It enters an IRS to swapping Floating Liability for Fixed Liability.
• Result: Asset and Liability structures match. Risk is eliminated.

C. Access to New Markets

• A small Indian company cannot issue bonds in New York. But it can borrow in India and swap the cash flows to Dollars, effectively simulating a Dollar loan.

3. Quality Spread Differential (QSD) Model

This is the formula to calculate "Total Gain".

1. Calculate the Spread in Fixed Rate Market (Difference between Co. A and Co. B).
2. Calculate the Spread in Floating Rate Market.
3. QSD = Fixed Spread - Floating Spread.
4. If QSD is positive, a Swap is beneficial.

4. Exam Notes: Writing the Answer

Question: "Discuss the economic complications and motives for entering into Swaps." (10 Marks)

Answering Structure:

1. Primary Motive: "To reduce the cost of borrowing by exploiting market imperfections."
2. Comparative Advantage: Mention the theory by David Ricardo.
3. QSD: Mention the term "Quality Spread Differential" as the measure of potential gain.

5. Quiz Time! 🎯

Loading quiz…