Quality spread differential

Quality spread differential (QSD) arises during an interest rate swap in which two parties of different levels of creditworthiness 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+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.