Question

A commercial bank has $200 million of floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with $200 million of fixed-rate deposits costing 9 percent. A savings bank has $200 million of mortgages with a fixed rate of 13 percent. They are financed with $200 million in CDs with a variable rate of T-bill rate plus 3 percent. (LG 10-7)

Discuss the type of interest rate risk each institution faces.

Propose a swap that would result in each institution having the same type of asset and liability cash flows.

Show that this swap would be acceptable to both parties.

Answer 1

As the Assets of the Commercial Bank are denominated in Floating Rate. (T-Bill+2 %), a decrease in the Interest rates would adversely impact the financial performance of this bank .

As the Liabilities of the Saings Bank are denominated in Floating Rate. (T-Bill+3 %), an increase in the Interest rates would adversely impact the financial performance of this bank .

Both the banks can save themselves from the Interest rate risk by Undergoing a Swap Where

The Commercial Bank agrees to pay interest on $200 million in floating rate (at T-Bill rate +2%) to the Savings bank every year

in exchange of

The Savings bank making an interest payment on $200 million at a fixed rate of 10.5% to the Commercial Bank every year

The above Swap would result in both the Banks having fixed rate assets and fixed rate liabilities

Doing so would result in

Net Asset of Commercial Bank is transformed from a floating rate asset to a fixed rate asset

The fixed rate earning = 10.5%

As it is greater than its financing rate, the terms will be acceptable to the Commercial Bank

and Net liability of Savings Bank is transformed from floating rate to a fixed rate

Net fixed rate to be paid on liability = T-bill+3%-(T-bill+2%)+10.5% = 11.5%

As it is less than what it earns on its Assets, the terms will be acceptable to the Savings Bank