Quality spread differential (QSD) arises during an

interest rate swap In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...

in which two parties of different levels of

creditworthiness Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal sum, principal payment, leading to disrupted Cash flow, cash flows and increased Colle ...

experience different levels of interest rates of debt obligations. A positive QSD means that a swap is in the interest of both parties. A QSD is the difference between the default-risk premium differential on the fixed- rate debt and the default-risk premium differential on the floating-rate debt. In general, the former is greater than the latter.

Example

If Company A can borrow at a fixed rate of 12% or at

LIBOR The London Inter-Bank Offered Rate (Libor ) was an interest rate average calculated from estimates submitted by the leading Bank, banks in London. Each bank estimated what it would be charged were it to borrow from other banks. It was the prim ...

+2%, while Company B can borrow at a fixed rate of 10% or at LIBOR+1%, then there is a difference of 2% in fixed rate borrowings, but of only 1% in floating rate borrowings. A difference of 1% therefore exists as the QSD, and a swap would benefit both parties. The benefits are experienced as, although Company B has an absolute advantage over Company A, Company A has a comparative advantage at floating borrowing. Assuming Company A and Company B are willing to split the arbitrage profits equally, Company A would borrow $1,000,000 at a rate of LIBOR + 2% from the debt markets, while Company B would borrow $1,000,000 at a rate of 10% from the debt markets. Company A would further agree to enter a swap where it pays Company B 9.5% on $1,000,000 in exchange for Company B paying Company A the LIBOR rate on $1,000,000. Company A would owe the debt markets LIBOR + 2%, and owe Company B 9.5%, but would receive LIBOR from Company B. On net, Company A would now owe a total of 11.5%, which is lower than the 12% fixed rate at which it could have originally borrowed. Company B would owe the debt markets 10%, and owe Company A LIBOR, but would receive 9.5% from Company A. On net, Company B would owe LIBOR + 0.5%, which is lower than LIBOR + 1% floating rate at which it could have originally borrowed. Therefore, both parties are able to benefit from entering into a swap with the other.

References

* derivatives (finance) swaps (finance) {{finance-stub