the Wealthy Canadian

Suppose that you and I are both planning on buying houses in the near future.  As luck would have it we both need the exact same size mortgage.  Both of us went out and got two quotes each for our mortgages.  The two quotes are for a fixed rate and a variable rate.  The following are our quoted rates:

Because you have a better credit rating than I do, you have an absolute advantage in both quotes.  However, the interest rate differentials are not the same.  You have a 1% advantage in the fixed rate, but only a 0.5% advantage in the variable rate.  Therefore, when we compare our possible mortgages, you have a comparative advantage in the fixed rate.  Are you ready for the curve ball?  I have a comparative advantage in the variable rate.  Why, because you have me beat by a larger degree in the fixed rate.

You happen to think that interest rates are certainly going to go down so you would prefer to buy the variable rate mortgage.  I, on the other hand, think that rates can go nowhere but up so will get a fixed rate.

You and I, being the creative types, engineer a swap to leverage our comparative advantages.

• You get the fixed loan (even though you want the variable)
• I get the variable (even though I want the fixed)
• You and I then agree to swap payments (we are called counterparties to this agreement):
  • I pay you 5.75% (I’ll explain this number later)
  • You pay me Prime

  

Therefore, when you add up what we pay in total:

We both end up with the type of loan that we wanted at a better rate than we were quoted.  That is the reason for the odd 5.75% payment that I promised that I would explain, it is where we make use of both our comparative advantages to give us both a better rate.

1. Find the difference between the two fixed rates: 7.0-6.0 = 1.0%
2. Find the difference between the two variable rates: (Prime +1.0) – (Prime + 0.5%) = 0.5%
3. Take the difference between the above two: 1.0% – 0.5% = 0.5%
4. That number is the rate advantage that we can share.  So divide it by two.  0.5/2 = 0.25%

Therefore, instead of a direct swap of payments, I pay you 0.25% less than what You are paying to the bank, and we both come out ahead.

The big risk in this is that we have to trust each other to honour our payments to each other regardless of how prime moves. This is the simplest type of swap, called a Plain Vanilla Swap, but one of its siblings has been implicated in the global economic woes – the Credit Default Swap