A commercial bank has $200 million of four-year maturity floating-rate loans yie

Question

A commercial bank has $200 million of four-year maturity floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with $200 million of four-year maturity fixed-rate deposits costing 9 percent. The commercial bank can issue four-year variable-rate deposits at the T-bill rate plus 1.5 percent. A savings bank has $200 million of four-year maturity mortgages with a fixed rate of 13 percent. They are financed with $200 million in four-year maturity CDs with a variable rate of the T-bill rate plus 3 percent. The savings bank can issue four-year long-term debt at 12.5 percent.

Discuss the type of interest rate risk each FI faces.

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

Show that this swap would be acceptable to both parties.

The realized T-bill rates over the four-year contract period are as follows:

End of Year

T-Bill Rate

1

    1.75%

2

2.00

3

2.25

4

2.50

Calculate the realized cash flows on the swap and the net interest yield for the savings bank and the commercial bank over the contract period.

What are some of the practical difficulties in arranging this swap?

End of Year

T-Bill Rate

1

    1.75%

2

2.00

3

2.25

4

2.50

Explanation / Answer

a) The presence of interest rate risk is caused due to the variations in the interest rate in the bonds. In the given case, the savings bank will have increase in the expense level because of its higher interest rate exposure. The commercial bank will have lower income from interest because they are facing fall in the interest rate. Thus, the profit element will suffer in both the cases.

b) Commercial bank will receive interest @9% (fixed rate) from savings bank and should make payment as per variable rate of the T-bill rate plus 1 percent.

c)

Particulars

Savings bank

Commercial Bank

T bill + 3%

9%

Less: Swap rate

(T bill + 1%)

(9%)

Add: Swap rate

T bill +1%

9%

Cost of net financing

T bill + 1%

11%

e)

End of year

T bill rate + 1%

T bill

Cash payment by savings bank

Cash payments by bank

Net payments made by savings bank

1

2.75%

1.75%

$22 million

$5.5 million

$16.5 million

2

4%

2%

$22 million

$8.0 million

$14.0 million

3

4.25%

2.25%

$22 million

$8.5 million

$13.5 million

4

3.5%

2.5%

$22 million

$7.0 million

$15.5 million

f) In the above case, the assets related to the floating rate may not be related to or directly linked to floating rate liabilities at the same prevailing rate because of the risk. Notional amount of swap will not match with the interest payments if the amortization of the mortgages is adopted.

Particulars

Savings bank

Commercial Bank

T bill + 3%

9%

Less: Swap rate

(T bill + 1%)

(9%)

Add: Swap rate

T bill +1%

9%

Cost of net financing

T bill + 1%

11%

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