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ECON 3P03 (19)

Strategies to Manage Interest Rate Risk.docx

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Brock University
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Bank B Assets Liabilities Variable-rate loans $20M Variable-rate deposits $70M (T-Bill rate +1%) Fixed-rate loans(4%) $80M Fixed-rate CDS $20M Equity capital $10M Bank B has a negative gap ($20M-$70M= - $50) because it has funded fixed-rate customer loans (for which it receives 4%) with the sale of variable-rate deposits (on which it pays on average the 91-day T-bill rate plus 1 percent). Its earnings are at risk if interest rate rises △ profits = △i x GAP = △i x -$50M (list BankA&B’s balance sheet here!) -Each bank can remove its undesirable gap (assumed to be $50 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 $50M BankA agrees to pay Bank B the T-bill rate plus 1% on the notional principal. This is no problem for BankA since this is the rate that it receives on its $70M 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 BankA 4% on the notional principal. This is no problem for Bank B as this is the rate that it receives on its $80M fixed-rate loans. Bank A benefits from the swap because it is protected from falling interest rate that will reduce its variable-loan revenue. Strategies to Manage Interest Rate Risk Disadvantages of interest-rate swaps:  Swap markets suffer from lack of liquidity  They are subject to default risk  Should interest rate rise, Bank A will be tempted to default on the swap contract and vise versa.  Alternatively, one of the parties could go bankrupt exposing the other to interest rate risk. Strategies to Manage Interest Rate Risk (Hedging Through a Forward Contract) (b)Arrange Hedge through a forward contract. Bank B sells Bank A $50M of 10-year government of Canada Bonds ($50,000,000 / 120 = 417 bonds) to be delivered after one year. Bank B is said to have taken a short position. Should interest rates fall between now and next year. Bank A will suffer a decrease in its operating profits. However, the price of government bonds to which it will be entitled will have increased relative to the price it has agreed to pay in the forward contract (capital
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