Comparative Advantage Swaps

B

The correct answer is C. Interest rate swaps.

An interest rate swap is a financial derivative contract in which two parties agree to exchange interest rate cash flows based on a notional principal amount. The purpose of the swap is to allow the parties to manage their interest rate exposure and to take advantage of their comparative advantages in the borrowing market.

In an interest rate swap, one party agrees to pay a fixed rate of interest on a notional amount of money, while the other party agrees to pay a floating rate of interest on the same notional amount. The floating rate is usually tied to a benchmark rate, such as LIBOR, while the fixed rate is agreed upon at the outset of the contract.

The parties to an interest rate swap can be any two entities with interest rate exposure, including corporations, financial institutions, governments, and individuals. By entering into the swap, the parties can each obtain financing at the interest rate that is most advantageous to them.

For example, suppose that a U.S. corporation has the ability to borrow money in the U.S. at a lower fixed rate than it can borrow money in Europe, where interest rates are generally higher. Conversely, a European corporation may have the ability to borrow money in Europe at a lower floating rate than it can borrow money in the U.S. In this case, the two corporations could enter into an interest rate swap in which the U.S. corporation agrees to pay a fixed rate to the European corporation, while the European corporation agrees to pay a floating rate to the U.S. corporation. This would allow both corporations to obtain financing at the interest rate that is most advantageous to them, while transferring the interest rate risk to the other party.

In summary, interest rate swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets, making them the correct answer to this question.