So far we have merely described an interest-rate swap and looked at its characteristics. Here we illustrate how they can be used in asset/liability management. Other types of interest-rate swaps have been developed that go beyond the generic or “plain vanilla” swap described and we describe these later.

An interest-rate swap can be used to alter the cash flow characteristics of an institution’s assets so as to provide a better match between assets and liabilities. The two institutions we use for illustration are a commercial bank and a life insurance company.

Suppose that a bank has a portfolio consisting of five-year term commercial loans with a fixed interest rate. The principal value of the portfolio is $50 million, and the interest rate on all the loans in the portfolio is 10%. The loans are interest-only loans; interest is paid semiannually, and the principal is paid at the end of five years. That is, assuming no default on the loans, the cash flow from the loan portfolio is $2.5 million every six months for the next five years and $50 million at the end of five years. To fund its loan portfolio, assume that the bank is relying on the issuance of six-month certificates of deposit. The interest rate that the bank plans to pay on its six-month CDs is six-month LIBOR plus 40 basis points.

FundsThe risk that the bank faces is that six-month LIBOR will be 9.6% or greater. To understand why, remember that the bank is earning 10% annually on its commercial loan portfolio. If six-month LIBOR is 9.6%, it will have to pay 9.6% plus 40 basis points, or 10%, to depositors for six-month funds and there will be no spread income. Worse, if six-month LIBOR rises above 9.6%, there will be a loss; that is, the cost of funds will exceed the interest rate earned on the loan portfolio. The. bank’s objective is to lock in a spread over the cost of its funds.

The other party in the interest-rate-swap illustration is a life insurance company that has committed itself to pay a 9% rate for the next five years on a guaranteed investment contract (GIC) it has issued. The amount of the GIC is $50 million. Suppose that the life insurance company has the opportunity to invest $50 million in what it considers an attractive five-year floating-rate instrument in a private placement transaction. The interest rate on this instrument is six-month LIBOR plus 160 basis points. The coupon rate is set every six months. The risk that the life insurance company faces in this instance is that six-month LIBOR will fall so that the company will not earn enough to realize a spread over the 9% rate that it has guaranteed to the GIC holders. If six-month LIBOR falls to 7.4% or less, no spread income will be generated.

To understand why, suppose that six-month LIBOR at the date the floating-rate instrument resets its coupon is 7.4%. Then the coupon rate for the next six months will be 9% (7.4% plus 160 basis points). Because the life insurance company has agreed to pay 9% on the GIC policy, there will be no spread income. Should six-month LIBOR fall below 7.4%, there will be a loss.

We can summarize the asset/liability problems of the bank and the life insurance company as follows.

BANK:

  1. Has lent long term and borrowed short term.
  2. If six-month LIBOR rises, spread income declines.

LIFE INSURANCE COMPANY:

  1. Has lent short term and borrowed long term.
  2. If six-month LIBOR falls, spread income declines.

Now let’s suppose the market has available a five-year interest-rate swap with a national principal amount of $50 million. The swap terms available to the bank are as follows:

  1. Every six months the bank will pay 8.45% (annual rate).
  2. Every six months the bank will receive LIBOR.

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