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Quality spread differential
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<h2 id="example">Example</h2> <p>If Company A can borrow at a fixed rate of 12% or at <a href="/facts/LIBOR/NSACUahT">LIBOR</a>+2%, while Company B can borrow at a fixed rate of 10% or at LIBOR+1%, then there is a difference of 2% in fixed rate borrowings, but of only 1% in floating rate borrowings. A difference of 1% therefore exists as the QSD, and a swap would benefit both parties. The benefits are experienced as, although Company B has an absolute advantage over Company A, Company A has a comparative advantage at floating borrowing. </p><p>Assuming Company A and Company B are willing to split the arbitrage profits equally, Company A would borrow $1,000,000 at a rate of LIBOR + 2% from the debt markets, while Company B would borrow $1,000,000 at a rate of 10% from the debt markets. Company A would further agree to enter a swap where it pays Company B 9.5% on $1,000,000 in exchange for Company B paying Company A the LIBOR rate on $1,000,000. </p><p>Company A would owe the debt markets LIBOR + 2%, and owe Company B 9.5%, but would receive LIBOR from Company B. On net, Company A would now owe a total of 11.5%, which is lower than the 12% fixed rate at which it could have originally borrowed. </p><p>Company B would owe the debt markets 10%, and owe Company A LIBOR, but would receive 9.5% from Company A. On net, Company B would owe LIBOR + 0.5%, which is lower than LIBOR + 1% floating rate at which it could have originally borrowed. </p><p>Therefore, both parties are able to benefit from entering into a swap with the other. </p> <ul><li><a href="/facts/Paul_Collier/jUcgf1n2">Collier, Paul M.</a>; Aguei-Ampomah, Sam (2005). <i>Management Accounting-Risk and Control Strategy</i>. <a href="/facts/Elsevier/jkPSAEmR">Elsevier</a>. pp. 355–. <a href="/facts/ISBN_(identifier)/15AdSPa9">ISBN</a> 978-0-7506-6716-6.</li></ul>