Question

A U.S. bank has €10,000,000 deposit liabilities denominated in Euros (€) that must be repaid in two years. The deposits pay a fixed interest rate of 4%. The bank took the money raised and converted it to US dollars at the prevailing spot rate of $1.5/€, and made a dollar-denominated loan to a corporate customer who will repay the bank over the next two years in US dollars at a variable rate of interest equal to LIBOR +3%. The interest rate earned may change every six months.

Which of the following SWAP contracts could bank management use to reduce the bank’s interest rate and foreign exchange rate exposure?

Multiple Choice

• The US bank could enter into a SWAP agreement to pay fixed rate in €s at 3% in exchange for receiving payments in US$ based on LIBOR+3%.

• The US bank could enter into a SWAP agreement to make US$-denominated payments at LIBOR+2% in exchange for receiving €-denominated payments at 4%.

• The US bank could enter into a SWAP agreement to make €-denominated payments of LIBOR+2% in exchange for receiving US$-denominated payments at 4%.

• None of the above.

Answer 1

Answer.

Bank has fixed deposit of amounting €10000000, which required interest payment @4% pa

It is given that said money is being converted into $ at spot rate of 1€= $1.5 and given loan to corporate customer corresponding to which bank received interest @ LIBOR+3%,  

In a swap agreement option two is better for bank because it provide receiving of € denomination @4% which is just equal & opposite to its future liabilities and also provide payment of $ denomination @ LIBOR+2% which is opposite but lower than its future received i.e. @ LIBOR+3%

Now if we look at the diagram,

Payment in € is adjusted with liabilities in € .

However there is gain of 1% p.a on $ due to difference between receivable and payable (LIBOR+3%-LIBOR-2%) so, Net gain is of 1% p.a.

Answer (b)The US bank could enter into a SWAP agreement to make US$-denominated payments at LIBOR+2% in exchange for receiving €-denominated payments at 4%.