Question

10. A finance company has rate-sensitive assets of $20 million and rate-sensitive liabilities of $15 million. Should it be an interest-rate swap buyer (and make fixed-rate payments) or seller (and make variable-rate payments). Explain.

11. A bank has assets with an average duration of 3 years and liabilities with an average duration of 1.5 years. Should it be an interest-rate swap buyer (and make fixed-rate payments) or seller (and make variable-rate payments)? Explain.

12. A bank has a 4-year $30 million loan that pays annual payments of 9.5 percent and returns the principal at maturity. The bank can sell the loan with recourse at a price of $28.7 million and without recourse at a price of $26.8 million. If the probability of default (with no interest or principal being repaid) is 0.75 percent, should it sell the loan with or without recourse (assume risk neutrality)? Explain. [Note: the expected proceeds on the loan sale with recourse is the price times the probability that the loan will NOT default.]

13. Assume a bank originates a pool of short-term real estate loans worth $27 million with maturities of 3 years and with annual interest payments of 6.5 percent and return of principal at maturity. If the loans are converted to pass-through securities and the bank charges 45 basis points servicing fee per year, what is the payment expected by the holders of the securities at the end of the first year if 14% of the mortgages are expected to be prepaid?

Answer 1

10) Interest rate swaps are used to neutralize the interest rate risk related to the difference in sensitivity of assets and liabilities to interest rate movements. It can be used to transform the interest rate sensitive assets into interest rate-insensitive, and vice versa, and to transform the interest sensitive liabilities into interest rate insensitive and vice versa.Since the interest sensitive assets are greater than liabilities,it will disturb the balance between interest sensitive assets and liabilities, as interest sensitive assets will be for $ 5million bigger than the interest-sensitive liabilities. Therefore, he will enter the swap, if interest rates fall, the fall in income on the active side will be greater than the costs fall on the passive side, and the result will be a drop in profits. By entering into interest rate swap, the investor will eliminate this interest rate risk by converting $ 5 million of assets with variable income to $ 5 million of income with fixed income. In this case, if interest rates fell, the decline in interest sensitive income would be equal to drop in costs and profitability would remain unchanged. Therefore, investor will enter into interest rate swap in which he will have to pay at variable rate, and receive at fix. Profit/loss in swap would neutralize variable income from investments, and the net result will be a fixed income from the swap.Therefore, he will be an interest rate swap seller.