COMMERCIAL BANK PRACTICE & POLICY QUESTION.
8. Use the following information for a 2-year basic interest rate swap with the FHLB of Atlanta to answers parts a & b. LIBOR refers to 3-month LIBOR.
Swap A: Pay LIBOR Receive 2.93%
Swap B: Pay 2.87% Receive LIBOR
a. Your bank is liability sensitive through 2 years. It wants to use a basic interest rate swap to hedge (reduce) its interest rate risk. Which of the above swap positions (A or B) will reduce the bank’s interest rate risk? Provide your reasoning. Both swaps have a 2-year maturity with 3-month LIBOR as the floating rate.
b. Your bank has made a prime customer a 2-year fixed-rate loan at 5%. You want to use an interest rate swap to convert the fixed-rate loan to a floating-rate loan. Which swap (A or B) will achieve this objective? If the bank does the swap for the same principal amount as the loan (loan repayment is at the end of two years with interest paid quarterly matching the swap payments/receipts), what is the effective loan rate after you make the loan and add the swap? Show your calculation.