ECON 3P03 Lecture Notes - Interest Rate Swap, Interest Rate Risk, Vise
19 Dec 2013
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Its earnings are at risk if interest rate rises. Profits = i x gap = i x -m (list bank a&b"s balance sheet here!) Each bank can remove its undesirable gap (assumed to be million) by arranging an interest rate swap with the other. The simplest type of interest-rate swap (known as plain vanilla) specifies an amount on which interest is to be paid (notional principal) and a term for these payments (say 5 years). National principal in this case is assumed to be m. Bank a agrees to pay bank b the t-bill rate plus 1% on the notional principal. This is no problem for bank a since this is the rate that it receives on its m variable-rate loans. Bank b benefits from the swap because this stream of payments offsets its rising financing costs should interest rate rise. Bank b agrees to pay bank a 4% on the notional principal.
