What is ‘Quality Spread Differential – QSD’
The term ‘quality spread differential’, or QSD, refers to the difference between the price of a low-quality commodity and that of a high-quality commodity. For example, if a bushel of low-quality wheat is currently priced at $5, and a bushel of high-quality wheat is priced at $6, there would be a Quality Spread Differential QSD of $1. In general, buyers will pay more for higher quality goods.
However, in some cases factors such as supply and demand may override this principle, causing the quality spread differential QSD to decrease or even reverse. Typically, the quality spread and, hence, the quality spread differential can also vary within one commodity based on factors such as geographic location or time of year. Keeping track of the quality spread differential can provide valuable information for both sellers and buyers in the market.
Explaining ‘Quality Spread Differential – QSD’
For example, suppose ABC Corp can borrow fixed rate debt of 10.75% or at a floating rate of LIBOR. And let’s say that XYZ Corp. can borrow fixed rate debt of 10% or at a floating rate of LIBOR -0.25%. The fixed rate differential would be 0.75% and the floating rate differential would be 0.25%. The QSD would be 0.5%.
Since the quality spread differential QSD is positive, both companies would benefit from entering into a swap transaction.
Interest rate swap
The concept of an interest rate swap may seem confusing at first, but it can actually be a valuable tool for organizations and businesses.
A typical Interest rate swap is a contractual agreement between parties to exchange a series of fixed rate payments for floating interest payments, or vice versa. This can be useful for managing risk and balancing out fluctuations in market interest rates. For example, if a company has taken out a fixed rate loan but expects market fixed rates to drop, they could enter into an interest rate swap with another party in order to switch to a variable rate loan.
Of course, there are also potential downsides to using swaps as they involve taking on additional financial risks. However, with careful consideration and planning, an fixed rate swap can be a useful strategy for managing finances in an uncertain economy.
Floating rate debt
Floating rate debt can be a useful tool for companies looking to manage their financial risk. Rather than having fixed rate payments, the interest rate on floating rate debt adjusts with a benchmark rate (such as the prime rate or LIBOR) which helps to protect against fluctuations in interest rates.
This can be advantageous in times of rising rates, as fixed rate debt may become more expensive to pay off. However, it’s important to note that when rates are falling, floating rate debt will also see a decrease in its interest payments.
In addition, some floating rate debt may have an interest rate cap, limiting how high the interest payment can go and providing additional protection against sudden increases. Overall, floating fixed rate debt can be a valuable option for businesses seeking to mitigate their risk exposure in an uncertain market.
Further Reading
- Alternative explanations of interest rate swaps: A theoretical and empirical analysis – www.jstor.org [PDF]
- Borrowing cost reduction by interest rate swaps––an option pricing analysis – www.sciencedirect.com [PDF]
- On the Performance Drivers of US Treasury Inflation-Protected Securities. – search.ebscohost.com [PDF]
- Monte Carlo Simulation Analysis on the Costs Reduction Argument of Interest Rate Swaps – absel-ojs-ttu.tdl.org [PDF]
- EVALUATING MONETARY POLICY MEASURES IN A SMALL PRIMARY-EXPORTING ECONOMY: THE CASE OF TRINIDAD & TOBAGO – www.jstor.org [PDF]
- A thumbnail sketch of derivative securities and their regulation – heinonline.org [PDF]
- The Fiscal Tool for Secondary Education Reform – www.jstor.org [PDF]
