2. A commercial bank has $200 million of 4-year maturity floating-rate loans yielding the T-bill rate plus 2%. These loans are financed with $200 million of 4-year maturity fixed-rate deposits costing 9%. The commercial bank can issue 4-year variable-rate deposits at the T-bill rate plus 1.5%. A savings bank has $200 million of 4-year maturity mortgages with a fixed rate of 13%. They are financed with $200 million of 4-year maturity CDs with a variable rate of the T-bill rate plus 3%. The savings bank can issue 4-year long-term debt at 12.5%.

(1) Discuss the type of interest rate risk each FI faces.

(2) Propose a swap that would result in each FI having the same type of asset and liability cash flows.

(3) Had each FI gone to the debt market for financing, the commercial bank would pay T-bill rate plus 1.5%, and the savings bank fixed 12.5%. What are the savings of each FI through the interest rate swap?

(4) The realized T-bill rates over the four-year contract period are as follows:

End of Year T-bill Rate

1 1.75%

2 2.00

3 2.25

4 2.50

Calculate the realized cash flows on the swap and the net interest yield for the savings bank and the commercial bank over the contract period.

(5) What are some of the practical difficulties in arranging this swap?