Interest Rate Swap and Comparative Advantage Analysis in Finance

This assignment delves into the concept of interest rate swaps, a financial derivative used to manage risk and exchange cash flows. It explains how swaps function, focusing on interest rate swaps, and highlights the advantages for both parties involved, particularly in hedging against interest rate fluctuations. The assignment provides a detailed example involving the Bank of Singapore and a Singapore company, demonstrating how they can achieve comparative advantages in interest rates through a swap agreement. The analysis includes the calculation of interest payments and illustrates how each party benefits from the arrangement, leading to cost savings and more favorable interest rates. The assignment also references a study by Benos et al. (2020), which supports the analysis of interest rate swap markets and liquidity.

Treasury and Risk Management

1. What is Swap?
It is one type of derivative agreement where two or more parties enter into the contract or
agreement to exchange their liabilities and cash inflows from various financial
instruments. Swaps are mostly used for hedging currency and risk related to interest
fluctuation. There are several types of swap such as commodity swap, debt-equity swap
interest rate swap, currency swap, and other swaps.
2. Why swap is beneficial to both the parties who enter into the swap contract?
Both parties involved in the swap agreement get the advantage of cost-benefit as both
parties initially borrow from the market and receive comparative benefits and then they
swap the interest liability and preferred currency.
3. Explain how each party gets a comparative advantage by entering into swap?
According to Benos et al. (2020, p-159), if the parties enter to swap interest rate then one
of the parties will be hedged from the risk of interest rate and the other party to the
contract will get profit from the fluctuating rate. In swap one of the cash flow is variable
while the other cash flow is fixed and the cash flows are based on index price, interest
rate, and fluctuating exchange rate.
4. Example of comparative advantage by applying interest rate swap
Suppose Bank of Singapore wants a debt which carries floating interest rate and the other
Singapore Company requires fixed interest rate debt
The Singapore Bank can get at 12.5 percent fixed rate or also at LIBOR and the
Singapore Company has an option to borrow at 1 percent above the rate of LIBOR or at
15 percent interest rate.

The Bank of Singapore issues debt of fixed rate of $100000 at 12.5% and the Singapore
company issues debt of floating rate of $ 100000 at 1 percent which is above LIBOR.
The interest payment on this swap will be:
Bank receives 13% from company and company receives LIBOR from bank
Interest cost to Singapore Company: 1% + LIBOR +13% - LIBOR =
14% which is less than 15%
Interest to Singapore bank: (12.5% - 13%) + LIBOR =
.05% + LIBOR which is
less than the LIBOR
Thus it can be seen that there is a comparative advantage to both parties
involved in hedging purposes through swap and are get the profit through arbitrage.

References
Benos, E., Payne, R. and Vasios, M., (2020). Centralized Trading, Transparency, and Interest
Rate Swap Market Liquidity: Evidence from the Implementation of the Dodd–Frank
Act. Journal of Financial and Quantitative Analysis, 55(1), pp.159-192.