A bank finds that its assets are not matched with its liabilities. It is taking floating-rate...

A bank finds that its assets are not matched with its liabilities. It is taking floating-rate deposits and making fixed -rate loans. How can swaps be used to offset the risk?

Expert Solution

Since bank is accepting floating rate deposits and making fixed rate loans it is facing market fluctuation risk. To avoid this risk bank should offer swap quotations and start accepting fixed rate deposits and floating rate loan. This arrangement will prevent bank from market fluctuation losses. Lets discuss how it works.

Assume if floating rate deposits goes high in market and because of which bank will need to pay more to its depositors then bank simultaneously will having floating rate loans on which it will earn more. This extra earning on floating rate loans will nullify extra payment on floating rate deposits and consequently income of bank will be stable.

To balance its extra fixed rate deposits bank should further lend loans to borrower. This extra loan should be floating rate loans so that in case LIBOR or other floating rates (subject to which swap rates are based) goes up it will support bank financials.

Therefore, bank should enter into a swap arrangements of floating rate deposit against fixed rate securities.

jeff jeffy answered 5 months ago

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