7. Using interest rate swaps to reduce interest rate risk Suppose that Foundation bank seeks to reduce its interest rate risk in regards to its holdings of fixed-rate (12%) mortgages via the use of interest rate swaps. To this end, Foundation and Epitome bank come to an agreement of a swap arrangement, whereby Epltome receives fixed-rate payments from Foundation's mortgages, equaling 10%. In exchange, Foundation receives variable payments from Epitome, equaling the LIBOR rate (the Interbank lending rate for Eurobanks). Assume that Foundation'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 Foundation bank for various possible values of LIBOR. 7% Possible Future LIBOR Rates 8% 9% 10% 11% 12% 12% 12% 12% 12% 12% 12% 7 8 9 10 11 12 4 3 2 1 0 12% 1296 12% 12% 12% 12% Unhedged Strategy Average rate on existing mortgages Average cost of deposits Spread Hedging with Interest Rate Swap Fixed interest eamed on fixed-rate mortgages Fixed Interest owed on swap Spread on fixed-rate payments Variable interest rate earned on swap Variable interest rate owed on deposits Spread on variable-rate payments Combined total spread when using swap 10 10 10 10 10 10 2 2 2 2 2 2 7 8 9 10 11 12 6 7 8 9 10 11 1 1 1 1 1 1 3 3 3 3 3 3 IF LIBOR IS 8%, Foundation's spread would be % if unhedged and % when hedged. Thus, hedging leads to a spread % i unhedged, and % when hedged. Thus, hedging leads to a IF LIBOR is 10%, Foundation's spread would be spread when LIBOR is 10%