3. Bank A has $100 million of mortgages with an adjustable rate of HIBOR + 2%. T

Question

3. Bank A has $100 million of mortgages with an adjustable rate of HIBOR + 2%. These assets are financed with $100 million of fixed-rate deposits costing 5%. Bank B has $100 million investment of fixed-income notes with a fixed rate of 7%, which are financed with $100 million in CDs with a variable rate of HIBOR + 1%.

a) Discuss the particular interest rate risk each bank faces.

b) Assuming equal negotiation power, propose a feasible interest rate swap and demonstrate how such a swap may help both banks from hedging their interest rate risk in question by computation of the net position and net funding cost for each bank as a result of the proposed swap. (Hint: equal negotiation power should prompt the two parties to look for either the same net position or the same savings on funding cost as the case may apply.)

Explanation / Answer

Bank A has $100 million of mortgages with an adjustable rate of HIBOR + 2%. These assets are financed with $100 million of fixed-rate deposits costing 5%. Bank B has $100 million investment of fixed-income notes with a fixed rate of 7%, which are financed with $100 million in CDs with a variable rate of HIBOR + 1%.

a) Discuss the particular interest rate risk each bank faces.

b) Assuming equal negotiation power, propose a feasible interest rate swap and demonstrate how such a swap may help both banks from hedging their interest rate risk in question by computation of the net position and net funding cost for each bank as a result of the proposed swap. (Hint: equal negotiation power should prompt the two parties to look for either the same net position or the same savings on funding cost as the case may apply.)

Bank A receives HIBOR+2% and pays 5%

Bank B receives 7% and pays HIBOR +1%

In case HIBOR rate rises bank B will be in loss. Thus Bank B has a risk of rising HIBOR rates

A pays HIBOR +x% and receives fixed rate

B pays fixed rate and receives HIBOR +x%

Let Bank A negotiate with Bank B to pay HIBOR+2% and receive 5%

Net Position of Bank A

Receives HIBOR +2% from the asset, passes the HIBOR +2% to Bank B in swap transaction. B pays 5% to A

.A pays back 5% as financing cost. Thus net Profit/Loss of A=0

Net Position of B

Receives 7% fixed from asset, passes 5% out of it to Bank A in swap transaction. B pays HIBOR+2% out of which B pays back the financing cost of HIBOR +1%

Thus net profit for Bank B= (7%-5%)+ (HIBOR+2%)-(HIBOR+1%)=3%

Now there is no interest rate HIBOR risk to any bank as A passes HIBOR to B in return to fixed interest rate and Bank B receives HIBOR from A to pay its liability in HIBOR

B makes a profit of 3% and A makes no profit. If the profit has to be divided equally between A and B equally i.e 1.5%

Then the possible new Swap transaction will be either of the below

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