A commercial bank has $200 million of four-year maturity floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with $200 million of four-year maturity fixed-rate deposits costing 9 percent. A savings bank has $200 million of four-year maturity mortgages with a fixed rate of 13 percent. They are financed with $200 million of four-year maturity CDs with a variable rate of the T-bill rate plus 3 percent.

a. One feasible swap would be for the commercial bank to send variable-rate payments of the T-bill rate + 1 percent (T-bill + 1%) to the savings bank and to receive fixed-rate payments of 9 percent from the savings bank. Show the effect of this Swap agreement on the net financing cost for each FI.

b. If, alternatively, the commercial bank can issue four-year variable-rate deposits at the T-bill rate plus 1.5 percent, and the savings bank can issue four-year long-term debt at 12.5 percent, would the proposed Swap above be acceptable to both parties?

c. 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.