Question

An insurance company owns RM50 million of floating-rate bonds yielding LIBOR plus 1 percent. These loans are financed by RM 50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. A finance company has RM 50 million of auto loans with a fixed rate of 14 percent. The loans are financed by RM 50 million of CDs at a variable rate of LIBOR plus 4 percent.

a)  What is the risk exposure of the insurance and finance company?

(b)Propose a mutually beneficial swap. Illustrate the proposed swap in diagram.

(c) In a swap arrangement, the variable-rate swap cash flow streams often do not fully hedge the variable-rate cash flow streams from the balance sheet due to basis risk. What are the possible sources of basis risk in an interest rate swap?

(c) What is maturity intermediation? Comment some of the ways in which the risks of maturity intermediation could be managed by financial intermediaries?

Answer 1

Answer a) The insurance company is exposed to fall in interest rates on the asset side of the balance sheet whereas the finance company is exposed to rise in interest rates on the liability side of the balance sheet.

Answer b)

A swap can be proposed where fixed-rate payments from the finance company to the insurance company will offset the payments on the fixed-rate liabilities with the insurance company . The opposite occurs regarding the variable or floating -rate swap payments from the insurance company to the finance company. Both the companies have durations much closer to zero on this portion of their respective balance sheets.

Diagram of Swap

Answer c)

Basis risk is the risk of imprerfect hedging due to mediums which affect the difference between the future contracts and the underlying cash position. The possible sources of basis risk in an interest rate swap are as follows:

1. The variable or floating-rate index on the liabilities in the cash market may not perfectly match with the variable or floating -rate index negotiated in the swap agreement. This is very similar to the cross-hedging risk with the utilisation of futures contracts.

2. The premium over the index may change over time as credit or default risk conditions change.

Answer d)

Maturity Intermediation is the process of lending long term loans by borrowing funds on short term interest rates.

When financial intermediaries borrow money from certificates of deposit, demand deposits and other short term sources of finance and then lends the money raised as a 10-year mortgage, it engages in maturity intermediation.

This practice take banks in a risky position due to short-term funding raising costs that may rise quickly.

Ways in which risks of maturity intermediation can be managed by financial intermediaries:

If net borrowers & net lenders have different optimal time horizons Financial Itermediaries can service both sectors by matching their asset and liability maturities via:

-on and off balance sheet hedging activities

-flexible access to the financial markets