1. How could a bank utilize an interest rate swap, if it has a classic “floating...

1. How could a bank utilize an interest rate swap, if it has a classic “floating rate deposits as liabilities and fixed rate loans as assets” balance sheet? What would it choose to pay in a swap, what would it choose to receive?

A. It would choose to pay fixed and receive floating

B. It would choose to receive fixed and pay to float

2. The reason the bank in question 1 might seek to enter an interest rate swap is that:

A. changes in interest rates cause its liabilities reset more quickly than its assets

B. changes in interest rates cause its assets to reset more quickly than its liabilities

3. The bank in question 1 might seek to mitigate fixed rate asset exposure by investing in adjustable-rate mortgages or floating rate commercial loans (T or F)

Expert Solution

1. An interest rate swap is an agreement between two parties to exchange one flow of interest payments for another. So the swap usually converts a fixed interest rate into floating interest rate and vice versa. This way the companies hedge against the interest rate risk associated with future cash flows. So in this case the swap will be:

that floating rate deposits will become fixed rate deposits and fixed rate loans would be floating rate loans.

Hence option A is correct. It will choose to pay fixed and receive in floating.

2. The assets are fixed in nature for the bank and the liabilities are floating in nature. So the reason for the bank to enter in the interest rate swap is because any change in interest rates will reset the liabilities and not assets which are at a fixed interest rate. The risk side for the bank is the change in interest rate which will have an immediate impact on the liabilities. Hence option A is right.

3. True.

Adjustable rate mortgage is a type of mortgage in which the interest rate varies through out the life of the loan. The initial interest rate is fixed and which gets revised periodically.

Floating rate commercial loans are issued by banks to companies. The loans are like mortgage backed securities wherein an investor can buy in packaged mortgages and receive a return from the various mortgages included in the package.

Banks use instruments like these two to mitigate fixed rate asset exposure.

jeff jeffy answered 1 year ago

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