Question

A U.S. bank has deposit liabilities denominated in euros that must be repaid in 2 years. The deposits pay a fixed interest rate of 4%. The bank took the money raised and converted it to dollars, whereupon it lent the dollars to a corporate customer who will repay the bank over the next two years in dollars at a variable rate of interest equal to LIBOR +3%. The interest rate earned may change every six months.

Design a swap that the bank could use to reduce their risks.

Answer 1

In this question the major risk that bank has is mainly because bank has to pay a fixed interest rate however on the loans, they receive a variable interest rate (LIBOR + 3%). Now the risk is if LIBOR rate is below 1%, bank will have to pay and incur losses.

A swap can be constructed in various forms like fixed v/s variable, variable v/s variable.

In this case since bank is paying fixed rate in EURO and receiving floating rate in Dollars, bank should enter a swap where they receive fixed (4%) in EURO and pay a variable (e.g. LIBOR+ 2%) in USD.

By entering such swap, Bank would receive a fixed interest rate from Swap and pay against deposit liabilities. In exchange, bank will pay the variable interest rate to swap counterparty. This variable would be paid by Bank after receiving variable rate against the dollar loan.

You would notice that I have kept variable side of swap as LIBOR + 2%. This is kept intentionally. This would be the commission that bank will earn from this whole transaction. Bank will earn 1% dollar interest rate.

Below is a basic cash-flow the above swap (arrangement between Bank and counterparty is Swap)