PRACTICE PROBLEM 1

Consider a bank that holds a $5 million loan at a fixed rate of 6 percent for three
years, with quarterly payments. The bank had originally funded this loan at a fixed
rate, but because of changing interest rate expectations, it has now decided to fund it
at a floating rate. Although it cannot change the terms of the loan to the borrower, it
can effectively convert the loan to a floating-rate loan by using a swap. The fixed rate
on three-year swaps with quarterly payments at LIBOR is 7 percent. We assume the
number of days in each quarter to be 90 and the number of days in a year to be 360.
A. Explain how the bank could convert the fixed-rate loan to a floating-rate loan
using a swap.
B. Explain why the effective floating rate on the loan will be less than LIBOR.
SOLUTIONS
A. The interest payments it will receive on the loan are $5,000,000(0.06)(90/360) =
$75,000. The bank could do a swap to pay a fixed rate of 7 percent and receive
a floating rate of LIBOR. Its fixed payment would be $5,000,000(0.07)(90/360) =
$87,500. The floating payment it would receive is $5,000,000L(90/360), where
L is LIROR established at the previous reset date. The overall cash flow is thus
$S,OOO,OOO(L - 0.01)(90/360), LIROR minus 100 basis points.
B. The bank will effectively receive less than LIBOR because when the loan was
initiated, the rate was 6 percent. Then when the swap was executed, the rate was
7 percent. This increase in interest rates hurts the fixed-rate lender. The bank
cannot implicitly change the loan from fixed rate to floating rate without paying
the price of this increase in interest rates. It pays this price by accepting a lower
rate than LIBOR when the loan is effectively converted to floating. Another factor
that could contribute to this rate being lower than LIROR is that the borrower's
credit risk at the time the loan was established is different from the
bank's credit risk as reflected in the swap fixed rate, established in the LIBOR
market when the swap is initiated.
Equipped with our introductory treatment of the duration of a swap, we are now in
a position to move on to understanding how to use swaps to manage the risk of a longerterm
position that is also exposed to interest rate risk.
51 2 Chapter 8 Risk Management Applications of Swap Strategies
2.2 USINGSW APS We saw in the previous