2. Consider the following two financial institutions: Muddy Hole Finance: Assets Llabilities cal loans (CD rate + 4%) Medium-term notes (4-year, 8%) $400m $400m Comwallis Bank: Assets Liabilities Short-term CDs Fixed-rate mortgages (4-year, 9.5%) $400m (1-year) $400m Managers of the Muddy Hole Finance Co. are concerned that interest rates may fall over the next four years, while managers of the Cornwallis Bankare concerned that interest rates may rise over the next four years. Managers of Muddy Hole think that they could attract an additional $400 million in short- term deposits that are indexed to the CD rate (say, CD plus 2 percent). The proceeds of these deposits can be used to pay off the medium-term notes, which will help the institution to manage interest rate risks. Alternatively, Muddy Hole could go off the balance sheet and sell an interest rate swap. On the other hand, Cornwallis Bank could issue long-term notes with a maturity equal or close to that on the mortgages (at, say, 9 percent). The proceeds of the sale of the notes can be used to pay off the CDs and refice the interest rate risk. Alternatively, the savings bank could hedge this interest rate risk exposure by going off the balance sheet and buying a swap. Under an interest rate swap contract, Cornwallis Bank sends fixed payments of 8 percent per year of the notional $400 million value of the swap to Muddy Hole Finance Co, each year for 4 years, to allow the money center bank to cover fully the coupon interest payments on its note issue. In retum, Muddy Hole sends annual payments indexed to the one-year CD rate + 1 percent, for 4 years to help Cornwallis Bank cover the cost of refinancing its one- year renewable LIBOR deposits. a. Calculate the gain over the market rates for Muddy Hole and Cornwallis from the swap. b. Assume that the realized or actual path of CD rates over the four-year life of the swap contract is as follows End of Year CD Rates 1 8.0% 2 7.0% 3 6.0% 4.5% 2 Calculate the swap payments made by Muddy Hole and Cornwallis over the four-year swap period. c. Calculate the net income for Muddy Hole and Cornwallis over the four-year swap period. 2. Consider the following two financial institutions: Muddy Hole Finance: Assets Llabilities cal loans (CD rate + 4%) Medium-term notes (4-year, 8%) $400m $400m Comwallis Bank: Assets Liabilities Short-term CDs Fixed-rate mortgages (4-year, 9.5%) $400m (1-year) $400m Managers of the Muddy Hole Finance Co. are concerned that interest rates may fall over the next four years, while managers of the Cornwallis Bankare concerned that interest rates may rise over the next four years. Managers of Muddy Hole think that they could attract an additional $400 million in short- term deposits that are indexed to the CD rate (say, CD plus 2 percent). The proceeds of these deposits can be used to pay off the medium-term notes, which will help the institution to manage interest rate risks. Alternatively, Muddy Hole could go off the balance sheet and sell an interest rate swap. On the other hand, Cornwallis Bank could issue long-term notes with a maturity equal or close to that on the mortgages (at, say, 9 percent). The proceeds of the sale of the notes can be used to pay off the CDs and refice the interest rate risk. Alternatively, the savings bank could hedge this interest rate risk exposure by going off the balance sheet and buying a swap. Under an interest rate swap contract, Cornwallis Bank sends fixed payments of 8 percent per year of the notional $400 million value of the swap to Muddy Hole Finance Co, each year for 4 years, to allow the money center bank to cover fully the coupon interest payments on its note issue. In retum, Muddy Hole sends annual payments indexed to the one-year CD rate + 1 percent, for 4 years to help Cornwallis Bank cover the cost of refinancing its one- year renewable LIBOR deposits. a. Calculate the gain over the market rates for Muddy Hole and Cornwallis from the swap. b. Assume that the realized or actual path of CD rates over the four-year life of the swap contract is as follows End of Year CD Rates 1 8.0% 2 7.0% 3 6.0% 4.5% 2 Calculate the swap payments made by Muddy Hole and Cornwallis over the four-year swap period. c. Calculate the net income for Muddy Hole and Cornwallis over the four-year swap period
