Assume a currency swap in which two counterparties of comparable
credit risk each borrow at the best rate available, yet the nominal
rate of one counterparty is higher than the other. After the initial
principal exchange, is the counterparty that is required to make
interest payments at the higher nominal rate at a financial
disadvantage to the other in the swap agreement?

If the cost advantage of interest rate swaps would likely be
arbitraged away in competitive markets, what other explanations exist
to explain the rapid development of the interest rate swap market?

Hi Herbet,

It seems that you took your exemple from an old book,  because cost
advantage has been arbitraged a long time ago. The answer to your
first question is yes, its arbitraged.

if you want to learn about swaps, there's only one book: "Pricing and
Hedging Swaps" - by Paul Miron, Philip Swannell. it expensive, and out
of print, but you should find it at every swap desk in ny or london.

There are many reasons for the development of swaps, mainly:

For currency swaps:
- They are used to adjust supply of bonds to demand. ex: let's say a
US corporate need to borow $ to finance a plant in the US, but demand
at the moment for $ denominated bonds is very low (due to negative
views on the currency by international bonds investors, negative views
caused by the huge and growing holdings of $ in china/japan). This
corporate can issue his bond in euro (where demand is strong) and swap
back his euros into dollars, to finance his plant in $ (therefore
avoiding ccy risk). It could also be a swedish corporate, needing to
finance a US venture, in $. But this corp is a nobody in the US, so he
cannot find US buyers for his bonds. He can issue in localy in sweden,
in kronas, and swap back in usd, thank to a ccy swap.

- avoiding ccy risk:
A tennis tournement in the UK, selling future retransmition rights to
intl tv networks (in their local ccy), will want to swap back all
future revenues into sterling.

- ALM: do you need exemples?

- last but not least, hedge funds would typicaly play the carry games.
as u know, derivatives were created for hedgers, but speculators got
involved. ex:before 98, hedge funds would enter into 10 yrs ccy swaps
where they pay 0% in yen and receive 40% in russian. they void he
initial exchange in the fx mkt, by selling back the yen spot vs RUB.
they're left with a huge carry, and ccy risk. Worked very well until
it exploded in 98...
 
for irs:

- the main use is ALM: entities managing their interest rate risk. ie:
the pay the fix leg at the bottom of the recession, when swap rates
are at the lowest, and move to floating, at the top of the economic
boom, when rates are through the ceiling.

- asset swaps: an investor can transform a fixed coupon asset into a
floating rate asset, by paying the coupon (+accrued+ (100-bond price)
for a par-par asset swap, 99% of asset swaps) on a swap.

- irs are also used to hedge interest rate risks of ccy swaps. as you
know, a bank contracting a fixed-fixed ccy swap with a client is
exposed to interest rate risks in both currencies (which are hedged
with 2 irs), a basis risk, which is the risk of a change in the libor
margin to exchange 2 ccy (hedged with a basis swap), and a residual fx
exposure (depending on the size of the profit, and how close the fixed
rates are from current market rates)

- prop traders are also heavy users of swaps. with them, they can
place bets on the direction of rates(outright bets), on the slope of
the curve (steepner/flatner), the convexity of the curve
(barbels/butterflys), and realtive value bets (swap vs bonds).

i hope this helps..

good luck.

For derivative market growth rate, see www.isda.org:

from www.isda.org:
2003 MID-YEAR MARKET SURVEY 
The notional principal outstanding volume of vanilla interest rate
derivatives, which consist of interest rate swaps and options and
cross-currency swaps, grew by 24 percent to $123.90 trillion. A total
of 110 firms provided data on vanilla interest rate derivatives.
Adjusting for sample growth by comparing only those firms that
responded to both the Year-end 2002 and Mid-year 2003 Surveys,
outstandings grew by about 21 percent.

Credit derivatives continued their strong growth at 25 per cent in the
first six months of 2003 to $2.69 trillion, a similar rate of growth
to the previous six months. Credit derivatives in the Survey, include
credit default swaps, baskets and portfolio transactions. Adjusting
for sample growth, outstandings grew by 28 percent.

Finally, notional outstandings for equity derivatives, consisting of
equity swaps, options, and forwards, grew 14 per cent to $2.78
trillion. Adjusting for sample growth, equity derivatives were
essentially flat at 1.4 percent growth over the Year-end 2002 results.

For daily swap rates & historical curves: http://datacenter.treasury.erstebank.com/
go to data center / bonds / capital mkt derivatives / and choose your ccy.

enjoy.