A commercial bank agrees to pay a swap dealer a floating rate of interest on a $100 million in exchange for payment by the swap dealer to the bank of a fixed rate of interest on $100 million. At the same time, a manufacturing company agrees to pay the same swap dealer a fixed rate of interest on $100 million in exchange for payment by the swap dealer to the company of a floating rate of interest on $100 million identical to the floating rate paid by the bank to the swap dealer. The swaps are governed by standard swap documentation. Identify the risks of default, and explain which party bears a given risk of default.
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As the swaps are governed by standard swap documentation, the risk of default gets minimized because generally the standard swap documents are governed by International Swap and Derivative Association (ISDA) and under this association the documents are thoroughly reviewed to confirm that it has ...
Swaps in the commercial bank is analyzed in the solution. The risks of default are identified and explained.
Interest rate risk and swaps for commercial banks
A commercial bank has $200 million of floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with $200 million of fixed-rate deposits costing 9 percent. A savings bank has $200 million of mortgages with a fixed rate of 13 percent. They are financed with $200 million in CDs with a variable rate of T-bill rate plus 3 percent.
a. Discuss the type of interest rate risk each institution faces.
b. Propose a swap that would result in each institution having the same type of asset and liability cash flows.
c. Show that this swap would be acceptable to both parties
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