two institutions plan to issue $10 million in debt and are negotiating an intere

ID: 2789240 • Letter: T

Question

two institutions plan to issue $10 million in debt and are negotiating an interest rate swap that will help them lower there borrowing costs and obtain the preferred type (fixed rate or floating rate) of financing. Both are comparing their balance sheet alternatives with combined balance sheet and swap oportunities. Internet Bank has a negative GAP through three years, is liability sensitive, and would like to use the debt proceeds to invest in short term assets to reduce its interest rate risk.Brick & Mortar Bank has a positive GAP through three years, is asset sensitive, and would like to use its debt proceeds to invest in fixed rate assets to reduce its interest rate risk.Internet Bank can borrow at a 4.7% fixed rate for three years or pay the prevailing six month LIBOR plus 1 percent on floating rate debt. Brick & Mortar Bank can borrow at a 4.15% fixed rate for three years or the prevailing six month LIBOR plus 0.50 percent.

a. Explain whether and why Internet Bank needs fixed rate or floating rate funding to meet its objectives. do the same for Brick & Mortar Bank.

b. Assume that both banks issue either three year fixed rate debt or 6 month floating-rate debt on-balance sheet. They want to combine this with a basic swap to obtain the cheapest form of funding that helps reduce interest rate risk. Using the following basic swap terms, indicate what position each bank should take.Explain how and why it should meet the bank's objectives. Calculate the effective cost of borrowing that each bank ends up with.

Basic Swap Terms

This is all the info that is given by the problem in the book. copied directly from it. THERE IS NO MORE INFO

A. Pay 5.10% Receive 6 month LIBOR B. Pay 6 month LIBOR Recieve 5.06%

Explanation / Answer

1a)

Internet Bank

Brick & Mortar Bank

Difference

Fixed

4.7

4.15

0.55

Floating

Libor +1%

Libor+0.50%

0.5

Internet Bank is liability sensitive that mean it has more deposits than the loans it has made. It is more prone to risk from rising interest rates. It will prefer a fixed rate source of funding. On the other hand Brick and Mortar Bank is asset sensitive i.e. it has more assets than liabilities hence it would prefer floating rate source of funding to reduce risk.

1b)

The table in 1a above summarizes the cash market rates for both Internet Bank and Brick and Motor Bank. From the table we can see that Brick & Mortar bank has an absolute advantage over Internet Bank in terms of fixed or floating rate cost of borrowing. Internet Bank has a comparative advantage in Floating rate of borrowing (less difference), while Brick & Mortar has comparative advantage in Fixed rate of borrowing (more difference). Therefore, Internet Bank should take out a floating rate loan in the cash market while Brick & Mortar will take a fixed rate loan in the cash market.

Internet Bank Transaction

Cash Market: Issue 6 month floating rate debt at the rate of= LIBOR+1 %

Swap Transaction: Pay fixed rate to counterparty at 5.10

Receive 6 Month Libor from counterparty

(Net effect of the transaction is Pay fixed rate liability)

Brick & Mortar Bank

Cash Market: Issue fixed rate debt at the rate 4.15%

Swap Transaction: Pay 6 Month Libor to counterparty

Receive 5.06 % from Counterparty

(Net effect of the transaction is Pay Floating rate liability)

Interbank Net Cost=Pay 6 month Libor+ 1% + Fixed Rate of 5.10%-Receive 6 Month Libor

:=5.10+1=6.10%

Brick & Mortar Net Cost=Pay fixed rate of 4.25%+ Pay 6 month Libor-Receive fixed rate of 5.06%

= Pay 6 month Libor-0.81%