The swap terms available to the insurance company are as follows:

  1. Every six months the life insurance company will pay LIBOR.
  2. Every six months the life insurance company will receive 8.40%.

What has this interest-rate contract done for the bank and the life insurance company? Consider first the bank. For every six-month period for the life of the swap agreement, the interest-rate spread will be as follows:

 

Annual Interest Rate Received:
From commercial loan portfolio 10.00%

From interest-rate swap six-month LIBOR
Total 10.00% + six-month LIBOR

 

Annual Interest Rate Paid:
To CD depositors six-month LIBOR

On interest-rate swap 8.45%
Total 8.45% + six-month LIBOR

 

Outcome:
To be received 10.00% + six-month LIBOR

To be paid 8.45% + six-month LIBOR
Spread income 1.55% or 1.55 basis points

Thus whatever happens to six-month LIBOR, the bank locks in a spread of 155 basis points.

Now let’s look at the effect of the interest-rate swap on the life insurance company:

 

Annual Interest Rate Received:
From floating-rate instrument From interest-rate swap

Total

 1.6% + six-month LIBOR 8.40%
10.00% + six-month LIBOR
 

 

Annual Interest Rate Paid:
To GIC policyholders On interest-rate swap Total 9.00%

six-month LIBOR
9.00% + six-month LIBOR
 

 

Outcome:
To be received To be paid

Spread income

 10.00% + six-month LIBOR 9.00% + six-month LIBOR
1.0% or 100 basis points

Regardless of what happens to six-month LIBOR, the life insurance company locks in a spread of 100 basis points.Funds

The interest-rate swap has allowed each party to accomplish its asset/liability objective of locking in a spread.3 It permits the two financial institutions to alter the cash flow characteristics of their assets: from fixed to floating in the case of the bank, and from floating to fixed in the case of the life insurance company. This type of transaction is referred to as an asset swap. Another way the bank and the life insurance company could use the swap market would be to change the cash flow nature of their liabilities. Such a swap is called a liability swap.

Of course, there are other ways that two such institutions can accomplish the same objectives. The bank might refuse to make fixed-rate commercial loans. However, if borrowers can find someplace else willing to lend on a fixed-rate basis, the bank has lost these customers. The life insurance company might refuse to purchase a floating- rate instrument. But suppose that the terms on a private-placement instrument offered to the life insurance company were more attractive than those available on a comparable credit-risk floating-rate instrument, and that by using the swap market the life insurance company can earn more than it could by investing directly in a five-year fixed-rate bond. For example, suppose that the life insurance company can invest in a comparable credit risk five-year fixed-rate bond with a yield of 9.8%. Assuming that it commits itself to a GIC with a 9% rate, this would result in spread income of 80 basis points, less than the 100-basis-point spread income it achieves by purchasing the floating-rate instrument and entering into the swap.

Consequently, not only can an interest-rate swap be used to change the risk of a transaction by changing the cash flow characteristics of assets or liabilities, but under certain circumstances, it can also be used to enhance returns. Obviously, this depends on the existence of market imperfections.

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Application of a Swap to Asset/Liability Management continue…