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 (11%) 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 Phoenix's mortgages, equaling 9%. In exchange, Phoenix receives variable payments from Emblem, equating the LIBOR rate (the Interbank lending rate for Eurobanks) Assume that Phoenix's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%. The following table detalls the swap arrangement from the point of view of Phoenix bank for various possible values of LIBOR. 7% Possible Future LIBOR Rates 8% 9% 10% 11% 1196 11% 11% 11% 12% 11% 11% 6 7 B 9 10 11 5 4 3 2 1 0 11% 1196 119 11% 116 1196 Unhedged Strategy Average rate on existing mortgages Average cost of deposits Spread Hedging with Interest Rate Swap Fixed interest earned 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 9 9 9 9 9 9 2 2 2 2 2 2 7 B 9 10 12 8 7. 9 10 11 6 1 1 1 1 1 1 3 3 3 3 3 IF LIBOR Is 7%, Phoenix's spread would be u funhedged and % when hedged. Thus, hedging leads to a spread higher % if unhedged, and when hedged. Thus, nedging feads to ord IT LIBOR is 11%, Phoenix's spread would be when LIBOR 11% Tower Grade It Now Save & Continue