If we take a look at the interest rate offered to both companies from the market: Borrow U. Dollar Borrow British Pound Company A 8% 11.

10% 12%

Based on the market offer, company A has the comparative advantage of borrowing U.S. dollar, and company B has the comparative advantage of borrowing British pound (it is intuitive since company A is headquartered in U.S. and company B is headquartered in U.K.). However, company A wants British pound for its U.K. expansion, while company B wants U.S. dollar for its U.S. expansion.

The swap agreement: company A borrows U.S. dollar at 8% from the market, and company B borrows British pound at 12% from the market. Then they sit down and do the swap. After the swap, A pays net 11% on the British pound, and B pays net 9.4% on U.S. dollar.

The problem is, it looks like company B is completely ripping company A off!

Why doesn't company A just borrow U.S. dollar and exchange it to British pound to fund its business? This way, company A only pays 8% interest on U.S. dollar. Why on earth would company A agree to such a swap and eventually pay 11% interest on the British pound, even though 11% interest rate on British pound is 0.6% lower than the U.K. market offers? Why would company A ever want to pay interest based on U.K. market rate which is much higher than the rate in U.S. market?