Question

A regional bank holding company recently bought a $100 million package of mortgages that carry an average 8.5 percent yield. The holding company has established a subsidiary to manage this package. The subsidiary will finance the mortgage by selling 90-day commercial paper for which the current rate is 5.25 percent. The interest rate risk assumed by the subsidiary is evidenced by the difference in duration of the mortgages at six years and the duration of the commercial paper at 72 days. The holding company thus decides to arrange an interest rate swap through an intermediary bank to hedge the subsidiary's interest rate risk.

1.Should the subsidiary make floating-rate or fixed-rate payments in the swap market? Specifically, should the subsidiary pay fixed and receive floating, or pay floating and receive fixed? Use the following data to select specific swap terms. Explain why this swap should reduce the subsidiary's interest rate risk.

•Pay 7.37 percent and receive floating at 3-month LIBOR

•Pay 3-month LIBOR and receive 7.24 percent

Answer 1

The regional Bank Holding Company has obtained funding via commercial paper. In this , the BHC has to pay fixed interest payments to its investors. The risk to the company is interest rates falling such that the fixed interest rates it is paying is higher than the floating interest rates currently prevailing in the market . This would recommend a loss to the company . So the company would want to hedge against this .

One way to do this is to use a swap . Now the swap chosen to hedge against interest rate risk has to be one in which we receive fixed interest payments through which we can facilitate the interest payments to the investors and pay floating lower interest counterparties to our counterparty .

So if the interest rates fall in the market ,then our loss on the fixed interest payments to the investors would be offset by the profit on the swap and vice versa

So we will enter into the : Pay 3 month LIBOR and receive 7.24 percent