Suppose that Phoenix bank seeks to reduce its interest rate risk in regards to its holdings of fixed-rate (10%) mortgages via the use of interest rate swaps. To this end, Phoenix and Epitome bank come to an agreement of a swap arrangement, whereby Epitome receives fixed-rate payments from Phoenix's mortgages, equaling 8%. In exchange, Phoenix receives variable payments from Epitome, equaling the LIBOR rate (the interbank lending rate for Eurobanks). Assume that Phoenix's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%. The following table details the swap arrangement from the point of view of Phoenix bank for various possible values of LIBOR. Possible Future LIBOR Rates Unhedged Strategy 7% 8% 9% 10% 11% 12% Average rate on existing mortgages 10% 10% 10% 10% 10% 10% Average cost of deposits 5 6 7 8 9 10 Spread 5 4 3 2 1 0 Hedging with Interest Rate Swap Fixed interest earned on fixed-rate mortgages 10% 10% 10% 10% 10% 10% Fixed interest owed on swap 8 8 8 8 8 8 Spread on fixed-rate payments 2 2 2 2 2 2 Variable interest rate earned on swap 7 8 9 10 11 12 Variable interest rate owed on deposits 6 7 8 9 10 11 Spread on variable-rate payments Combined total spread when using swap 1 1 1 1 1 1 3 3 3 3 3 3 If LIBOR is 7%, Phoenix's spread would be % if unhedged and % when hedged. Thus, hedging leads to a spread. higher If LIBOR is 10%, Phoenix's spread would be when LIBOR is 10%. % if unhedged, and % when hedged. Thus, hedging leads to a spread lower
Suppose that Phoenix bank seeks to reduce its interest rate risk in regards to its holdings of fixed-rate (10%) mortgages via the use of interest rate swaps. To this end, Phoenix and Epitome bank come to an agreement of a swap arrangement, whereby Epitome receives fixed-rate payments from Phoenix's mortgages, equaling 8%. In exchange, Phoenix receives variable payments from Epitome, equaling the LIBOR rate (the interbank lending rate for Eurobanks). Assume that Phoenix's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%. The following table details the swap arrangement from the point of view of Phoenix bank for various possible values of LIBOR. Possible Future LIBOR Rates Unhedged Strategy 7% 8% 9% 10% 11% 12% Average rate on existing mortgages 10% 10% 10% 10% 10% 10% Average cost of deposits 5 6 7 8 9 10 Spread 5 4 3 2 1 0 Hedging with Interest Rate Swap Fixed interest earned on fixed-rate mortgages 10% 10% 10% 10% 10% 10% Fixed interest owed on swap 8 8 8 8 8 8 Spread on fixed-rate payments 2 2 2 2 2 2 Variable interest rate earned on swap 7 8 9 10 11 12 Variable interest rate owed on deposits 6 7 8 9 10 11 Spread on variable-rate payments Combined total spread when using swap 1 1 1 1 1 1 3 3 3 3 3 3 If LIBOR is 7%, Phoenix's spread would be % if unhedged and % when hedged. Thus, hedging leads to a spread. higher If LIBOR is 10%, Phoenix's spread would be when LIBOR is 10%. % if unhedged, and % when hedged. Thus, hedging leads to a spread lower
Intermediate Financial Management (MindTap Course List)
13th Edition
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Eugene F. Brigham, Phillip R. Daves
Chapter24: Enterprise Risk Management
Section: Chapter Questions
Problem 4P
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Transcribed Image Text:Suppose that Phoenix bank seeks to reduce its interest rate risk in regards to its holdings of fixed-rate (10%) mortgages via the use of interest rate
swaps. To this end, Phoenix and Epitome bank come to an agreement of a swap arrangement, whereby Epitome receives fixed-rate payments from
Phoenix's mortgages, equaling 8%. In exchange, Phoenix receives variable payments from Epitome, equaling the LIBOR rate (the interbank lending
rate for Eurobanks).
Assume that Phoenix's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%.
The following table details the swap arrangement from the point of view of Phoenix bank for various possible values of LIBOR.
Possible Future LIBOR Rates
Unhedged Strategy
7%
8%
9%
10% 11%
12%
Average rate on existing mortgages
10%
10%
10%
10%
10%
10%
Average cost of deposits
5
6
7
8
9
10
Spread
5
4
3
2
1
0
Hedging with Interest Rate Swap
Fixed interest earned on fixed-rate mortgages
10%
10%
10%
10%
10%
10%
Fixed interest owed on swap
8
8
8
8
8
8
Spread on fixed-rate payments
2
2
2
2
2
2
Variable interest rate earned on swap
7
8
9
10
11
12
Variable interest rate owed on deposits
6
7
8
9
10
11
Spread on variable-rate payments
Combined total spread when using swap
1
1
1
1
1
1
3
3
3
3
3
3
If LIBOR is 7%, Phoenix's spread would be
% if unhedged and
% when hedged. Thus, hedging leads to a
spread.
higher
If LIBOR is 10%, Phoenix's spread would be
when LIBOR is 10%.
% if unhedged, and
% when hedged. Thus, hedging leads to a
spread
lower
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