7. Using interest rate swaps to reduce interest rate risk

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 Emblem bank come to an agreement of a swap arrangement, whereby Emblem receives fixed-rate payments from Phoenixs mortgages, equaling 8%. In exchange, Phoenix receives variable payments from Emblem, equaling the LIBOR rate (the interbank lending rate for Eurobanks).

Assume that Phoenixs 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.

Unhedged Strategy	Possible Future LIBOR Rates
	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	1	1	1	1	1	1
Combined total spread when using swap	3	3	3	3	3	3

If LIBOR is 8%, Phoenixs spread would be

% if unhedged and

% when hedged. Thus, hedging leads to a spread.If LIBOR is 11%, Phoenixs spread would be

% if unhedged, and

% when hedged. Thus, hedging leads to a spread when LIBOR is 11%.

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 1 1 1 1 1 1 Combined total spread when using swap 3 3 3 3 3 3 If LIBOR is 8%, Phoenixs spread would be % if unhedged and % when hedged. Thus, hedging leads to a spread. If LIBOR is 11%, Phoenixs spread would be % if unhedged, and % when hedged. Thus, hedging leads to a spread when LIBOR is 11%.