Suppose the notional value of

Suppose the notional value of a swap is $100 million—equal to the size of the money center bank’s medium-term note issue—and the maturity of four years is equal to the maturity of the bank’s note liabilities. The annual coupon cost of these note liabilities is 10 percent, and the money center bank’s problem is that the variable return on its assets may be insufficient to cover the cost of meeting these coupon payments if market interest rates, and therefore asset returns, fall. By comparison, the fixed returns on the savings bank’s mortgage asset portfolio may be insufficient to cover the interest cost of its CDs if market rates rise. As a result, a feasible swap agreement might dictate that the savings bank send fixed payments of 10 percent per year of the notional $100 million value of the swap to the money center bank to allow the bank to cover fully the coupon interest payments on its note issue. In return, the money center bank sends annual payments indexed to one-year LIBOR to help the savings bank cover the cost of refinancing its one-year renewable CDs. Suppose that one-year LIBOR is currently 8 percent and the money center bank agrees to send annual payments at the end of each year equal to one-year LIBOR plus 2 percent to the savings bank. 4 We depict this fixed-floating-rate swap transaction in Figure 24–1 ; the expected net financing costs for the FIs are listed in Table 24–2.

                   As a result of the swap, the money center bank has transformed its four-year, fixed-rate interest payments into variable-rate payments, matching the variability of returns on its assets. Further, through the interest rate swap, the money center bank effectively pays LIBOR plus 2 percent for its financing. Had it gone to the debt market, we assumed that the money center bank would pay LIBOR plus 2.5 percent (a savings of 0.5 percent with the swap). Further, the savings bank has transformed its variable-rate interest payments into fixed-rate payments, plus a “small” variable component (CD rate  – LIBOR), similar to those received on its assets. Had it gone to the debt market, we assumed that the savings bank would pay 12 percent (a savings of 4 percent  +  CD rate  –  LIBOR with the swap).

Table 24–2

FIGURE 24–1

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