International Finance Ans 3 - Rev

Q3.
a) When borrowing at the same maturity in the same market (fixed rate or floating rate),
companies with a higher credit rating and companies with a lower credit rating pay different
interest rates, which is known as the Quality Spread (QS). For instance, the Quality Spread
(QS) on fixed-rate debt is 1% if Firm 1 is able to borrow at 2.5% fixed and Firm 2 is only able
to borrow at 3.5% fixed. This means that the QS on floating-rate debt is 0.5% where Firm 1
can borrow at LIBOR + 0.25% and Firm 2 can borrow at LIBOR + 0.75%.
The Quality Spread Differential, or QSD, is the difference in Quality Spreads between firms 1
and 2 in fixed-rate and floating-rate markets. In an interest rate swap, the QSD shows the
potential profits to both counterparties. By borrowing in the market where they have a
comparative advantage and moving cash flows if the QS differs between fixed and floating
markets, both enterprises can lower their borrowing costs.
An interest rate swap can be entered into if Firm 1 borrows at 2.5% fixed and Firm 2 borrows
at LIBOR + 0.75% floating. In this scenario, Firm 1 pays LIBOR to Firm 2 and receives a fixed
rate between 2.5% and 3.5%, while Firm 2 pays Firm 1 a fixed rate between 2.5% and 3.5%.
Because of this, both businesses are able to borrow money more economically when
entering into a swap as opposed to separately.
In interest rate and currency swaps, the Quality Spread (QS) and Quality Spread Differential
(QSD) have a major impact on interest rate decisions. These spreads provide information
about the parties involved in the anticipated credit risk of the swaps and affect the
additional rates applied to benchmark rates. A higher QS or QSD indicates a higher perceived
risk and causes spreads to rise, which affects the swaps' terms.
b) For fixed-rate debt and floating-rate debt, the Quality Spread (QS) is 1% and 0.5%,
respectively. This is an indication of a possible interest rate swap opportunity. Let us consider
an example where Firms 1 and 2 decide to divide the QSD equally, resulting in 0.25% savings
for each firm. This suggests that since + 0.25% - 0.25% equals LIBOR, Firm 1 essentially
borrows money at LIBOR.
In the meantime, Firm 2 borrows money at 3.5% minus 0.25%, or 3.25%. In a swap, firm 1
should pay firm 2 LIBOR while firm 2 pays firm 1 3.25%. According to the cash flows, Firm 1
would borrow money at LIBOR, pay Firm 2 LIBOR, and get 3.25% from Firm 2. For Firm 1
borrowing cost is thus LIBOR. For firm 2 cashflows, they would borrows at 3.25%, pays 3.25%
to Firm 1, receives LIBOR from Firm 1. Firm two’s borrowing cost is 3.25% since ( 3.25% +
LIBOR - LIBOR = 3.25%).
Each company receives a 0.5% Quality Spread Differential (QSD) and is able to obtain loans
at their desired interest rates (Firm 1 chooses a variable rate, while Firm 2 chooses a fixed
rate). The savings for both businesses are reduced, if a swap bank charges a commission by
changing the bid-ask spread. The effective QSD, would drop to 0.4% (0.5% - 0.1%) with a bid-
ask spread of 0.1%. Instead of the initially anticipated 0.25%, this modification causes each
firm to save 0.2%. As a result, the total cost of borrowing for Firm 1 would be LIBOR + 0.05%,
whereas for Firm 2, it would be 3.3%.
c) According to the statement provided in the question, there are no prospects for financial
benefit through arbitrage in the QSD under perfect information circumstances. Evidence
from Wall's study supports this statement. Wall's analysis expads upon links between
agency costs and market inefficiencies and the Quality Spread Differential (QSD). The Wall
study can be applied in this situation to highlight the asymmetric information that exists
across companies with varying credit ratings. Higher credit rating corporations can borrow
money at lower interest rates than other companies, which can lead to swap savings, which
is the rationale for the QSD.
In perfect circumstances, the QSD does not present chances for financial advantage through
arbitrage, according to the statement provided in the question. Information from Wall's
study lends additional credence to this.
In Wall's work, the relationships between agency costs and market defects and the Quality
Spread Differential (QSD) are explained. The asymmetric information between companies
with varying credit ratings are the main emphasis of this case study, based on the Wall
research. Due to their ability to borrow money at cheaper interest rates than other
companies, corporations with higher credit ratings are the driving force behind the QSD. This
can lead to swap savings. Taking advantage of one other's comparative advantages,
corporations can engage in swaps due to these variations in borrowing rates.
In our case, the difference in credit rating causes a variation in a QSD, which in turn causes a
variance in borrowing rates for firms 1 and 2. This presents a chance for arbitrage. This
opportunity would not be present if the cost of borrowing were the same. The theory of
liquidity preference offers an additional justification for this notion. Liquidity risk is the ease
of trading securities without impacting their prices. In this context, the difference in business
preferences between fixed and floating rates. Enterprises may exhibit a preference for one
type of rate over other due to differences in operational requirements or risk profiles.
The difference in preference leads to different borrowing costs for different firms. Businesses
use this difference to customize their debt arrangements tailored to their demands. For
instance, certain businesses would prefer fixed rates due to their consistency and
predictability, others might prefer floating rates due to their flexibility and possible cost
savings. Several variables, including market conditions, strategic goals, and risk tolerance,
impact these preferences. Thus the preference difference leads to QSD providing a chance
for arbitrage. The QSD cannot be arbitraged, or used for financial advantage, in the absence
of this difference.

International Finance Ans 3 - Rev

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