The bank is a price taker in both the fixed-rate market at 9 percent and the rate-sensitive market at the T-bill rate plus 1.5 percent. A securities dealer has a large portfolio of rate-sensitive assets funded with fixed-rate liabilities. The dealer is a price taker in a fixed-rate market paying 8.5 percent and a floating-rate market paying the 91-day T-bill rate plus 1.25 percent. All interest is paid annually.

a. What is the interest rate risk exposure to the securities dealer?

b. How can the bank and the securities dealer use a swap to hedge their respective interest rate risk exposures?

c. What are the total potential gains to the swap?

d. Consider the following two-year swap of cash flows: An annual fixed-rate cash flow of 8.6 percent in exchange for a floating-rate cash flow of T-bill plus 125 basis points. The swap intermediary fee is five basis points. How are the swap gains apportioned between the bank and the securities dealer if each hedges its interest rate risk exposures using this swap?

e. What are the realized cash flows if T-bill rates at the end of the first year are 7.75 percent and at the end of the second year 5.5 percent? Assume that the notional value of the swap is $107.14 million.

f. What are the sources of the swap gains to trade?
g. What are the implications for the efficiency of cash markets?