1. Why are interest rate swaps based upon the principle of comparative advantage?
2. For a swap to provide a real economic benefit to both parties, why must a barrier generally exist to prevent arbitrage from functioning fully?
Why interest rate swaps are based upon the principle of comparative advantage:
Dattatreya (1992) provides that an interest rate swap is a contractual agreement that exists between two parties whereby they agree to exchange a series of payments for a specified period of time. Interest rate swaps are based on the principle of comparative advantage because the principle explains how different countries that are experiencing different opportunity costs cab benefit from free trade (Kuprianov, 1994). According to Dattatreya (1992), interest rate swaps came about in the 1980s when borrowers took up the risk that arose due to mismatch between what is required and what is obtained. During this period financial institutions had comparative advantage depending on credit rating. In a floating market the lower rated borrower has comparative advantage when compared to higher rated borrower while the high rated borrower has comparative ...
The solution discusses why interest rates swap based upon the principles of comparative advantage.