A corporate treasurer tells you that he has just negotiated...

A corporate treasurer tells you that he has just negotiated a five-year loan at a competitive fixed rate of interest of $5.2 \%$. The treasurer explains that he achieved the $5.2 \%$ rate by borrowing at six-month LIBOR plus 150 basis points and swapping LIBOR for $3.7 \%$. He goes on to say that this was possible because his company has a comparative advantage in the floating-rate market. What has the treasurer overlooked?

Key Concepts

Interest Rate Swap

An interest rate swap is a financial derivative in which two parties agree to exchange streams of interest payments, typically swapping a fixed interest rate for a floating rate or vice versa. This instrument is often used to adjust the interest rate exposure of an existing debt without having to refinance the underlying loan.

Comparative Advantage in Borrowing

Comparative advantage in borrowing refers to the idea that different companies may obtain financing at lower rates in different markets (fixed vs. floating) relative to each other. This concept underpins strategies where a firm might exploit its relative strength in one market to secure better overall financing terms through swapping, even if its absolute advantage is in a different type of borrowing.

Basis Risk

Basis risk is the risk that arises when the reference rates underlying different financial instruments or swap legs do not move in perfect correlation. In the context of swapping a floating rate to a fixed rate, any mismatch between the floating rate on the loan and the floating rate in the swap can lead to unintended exposure, undermining the hedging strategy.

Counterparty Risk in Swaps

Counterparty risk in swaps refers to the possibility that the party on the other side of the swap agreement will fail to meet their contractual obligations. This risk is critical because it can affect the effectiveness and overall cost of the hedging strategy, a factor that must be considered along with the presumed comparative advantage in borrowing.

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