Good Company prefers variable to fixed rate debt. Bad Company prefers fixed to variable rate debt. Assume that Good and Bad Companies could issue bonds as follows:

Question

Good Company prefers variable to fixed rate debt. Bad Company prefers fixed to variable rate debt. Assume that Good and Bad Companies could issue bonds as follows:​

Quizplus · Accepted Answer

Since Good Company prefers variable rate debt and can issue it at a more attractive rate than Bad Company, it has a comparative advantage in this type of debt. On the other hand, Bad Company prefers fixed rate debt and can issue it at a more attractive rate than Good Company, giving it a comparative advantage in this type of debt. An interest rate swap could benefit both parties by allowing them to take advantage of their respective comparative advantages. Good Company could provide Bad Company with variable rate payments at LIBOR + 1 percent while receiving fixed rate payments of 10.5 percent, which is lower than the rate it could issue fixed-rate debt. Bad Company could provide Good Company with variable rate payments at LIBOR + 1 percent while receiving fixed rate payments of 10.5 percent, which is lower than the rate it could issue fixed-rate debt. However, since Good Company has a comparative advantage in variable rate debt, it is more likely that it would be the party providing the variable rate payments in the swap. Therefore, option B is the best choice as it presents a mutually beneficial scenario for both companies.

Good Company Prefers Variable to Fixed Rate Debt