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Answer: Reliable has a comparative advantage in floating-rate markets, but Dubious has a comparative advantage in fixed-rate markets
Reliable has the lower borrowing cost in both markets, but comparative advantage is determined by the *relative* cost difference between the two firms. - **Fixed-rate market spread:** 7.50% − 5.00% = **2.50%** - **Floating-rate market spread:** (LIBOR + 3.10%) − (LIBOR + 0.40%) = **2.70%** Reliable has the **greater advantage in floating-rate borrowing** because the cost difference is larger there (2.70% vs. 2.50%). Therefore, Reliable has the comparative advantage in **floating-rate markets**, while Dubious has the comparative advantage in **fixed-rate markets**. So the correct answer is **C**.
Author: Manit Arora
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Question 722.1. Consider two firms, Reliable Corp and Dubious Corp. Reliable Corp has a strong balance sheet and repayment history; it can borrow 5.0% in fixed-rate loan markets or, in floating-rate markets, Reliable can pay 40 basis points above six-month LIBOR. Dubious Corp has a weaker balance sheet and must pay 7.50% in fixed-rate loan markets or, in floating-markets, Dubious must pay 310 basis points above six-month LIBOR.
| Fixed Rate | Floating Rate | |
|---|---|---|
| Reliable Corp | 5.00% | 6-month LIBOR + 0.40% |
| Dubious Corp | 7.50% | 6-month LIBOR + 3.10% |
Which of the following statements is TRUE about this situation with respect to comparative advantage?
A
Neither has a comparative advantage in either market
B
Reliable has a comparative advantage in BOTH the fixed-rate and floating-rate markets
C
Reliable has a comparative advantage in floating-rate markets, but Dubious has a comparative advantage in fixed-rate markets
D
Reliable has a comparative advantage in fixed-rate markets, but Dubious has a comparative advantage in floating-rate markets
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