At their core, interest rate swaps are a derivative instrument built on the premise of comparative advantage. To see how interest rate swaps benefit both parties, try to understand gains from trade in a macro-setting and then apply those lessons to micro-swap transactions.

There are other possible advantages – information asymmetries might exist in capital markets, or the two parties may simply have different risk profiles – but the most common benefits are derived from comparative advantages in different credit markets.

What Is Comparative Advantage?

Comparative advantage refers to the ability of an entity to produce a good or service at a lower opportunity cost than another entity. This idea is centered on relative efficiency, not absolute efficiency.

Consider the following example: During a single hour of labor, Tom can either plant five trees or 10 bushes. During the same hour of labor, Jerry can either plant two trees or eight bushes. Tom is absolutely more efficient than Jerry in planting either type of plant.

However, for every bush that Tom plants, he gives up one-half of a tree (his opportunity cost); Jerry only has to sacrifice one-quarter of a tree to plant a bush. Jerry is relatively more efficient at planting bushes than Tom. This is Jerry's comparative advantage.

Suppose Tom plants one tree for Jerry in exchange for Jerry planting three bushes for him. On his own, Tom would normally have to give up one and a half trees to plant three bushes. Meanwhile, Jerry would have to give up four bushes to plant one tree on his own. By specializing and trading, both parties benefit.

Comparative Advantage in Interest Rate Swaps

Now, for instance, take the most simple version of an interest rate swap. One party trades fixed-rate interest payments in exchange for floating-rate interest payments of another party. Each demonstrates a comparative advantage in a particular credit market.

For instance, a company with a higher credit rating pays less to raise funds under identical terms than a less creditworthy company. The borrowing premium paid by the lower-rated company is greater in relation to fixed-interest rate borrowing than it is for floating rate borrowings.

Even though the company with a higher credit rating could get lower terms in both fixed and floating rate markets, it only has a comparative advantage in one of them. Suppose Company AA can borrow in the fixed-rate markets at 10 percent or the six-month LIBOR at LIBOR + 0.35 percent. Company BBB can borrow fixed at 11.25 percent or the six-month LIBOR + one percent.

Both companies would like to borrow $10 million over 10 years. A mutually profitable swap can be negotiated as follows: Company AA borrows at a 10 percent fixed-rate and BBB borrows at LIBOR + one percent. Company AA agrees to pay BBB interest at the flat six-month LIBOR (not + one percent) and receives a fixed rate of 9.9 percent in exchange.

The net effect is that Company AA is actually borrowing at LIBOR + 0.1 percent, or 0.25 percent less than if it went directly to floating-rate lenders. Company BBB is actually borrowing, on net, a fixed rate of 10.9 percent (the one percent on LIBOR and 9.9 percent to AA), which is 0.35 percent less than a direct fixed loan. In this example, the two companies have arbitraged their relative opportunity cost differences.