Question 2b
Answer

(b) Advantages of swaps
Transaction costs are generally relatively low. If Lurgshall Co arranged the swap itself, the costs would be limited to legal fees. The transaction costs may also be lower than the costs of terminating one loan and arranging another.

Lurgshall Co can, as here, swap a commitment to pay a variable rate of interest which is uncertain with a guaranteed fixed rate of interest. This allows Lurgshall Co to forecast finance costs on the loan with certainty.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever time period is required, unlike traded derivatives. The period available for the swap may be longer than is offered for other interest rate derivatives.

Swaps make use of the principle of comparative advantage. Lurgshall Co can borrow in the market where the best deal is available to it, and then use the swap to access the loan finance it actually wants at an overall cheaper cost.

Disadvantages of swaps
Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on the arrangement. This would apply in particular if Lurgshall Co arranged the swap itself. If it is arranged through a bank, the bank can provide a guarantee that the swap will be honoured.

If Lurgshall Co swaps into a fixed rate commitment, it cannot then change that commitment. This means it cannot take advantage of favourable interest rate changes as it could if it used options. This may be a particular problem if the swap period is more than a few months and interest rates are expected to be volatile.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if they are not needed or become no longer advantageous. It is possible that a bank may allow a reswapping arrangement to reverse a swap which is not required, but this will incur further costs.