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. The commercial bank can issue four-year variable-rate deposits at the T-bill rate plus 1.5 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 in four-year maturity CDs with a variable rate of the T-bill rate plus 3 percent. The savings bank can issue four-year long-term debt at 12.5 percent.

a. Discuss the type of interest rate risk each FI faces.

b. Propose a swap that would result in each FI having the same type of asset and liability cash flows. End of Year T-Bill Rate 1. 1.75% 2. 2.00 3. 2.25 4. 2.50

c. Show that this swap would be acceptable to both parties.

d. The realized T-bill rates over the four-year contract period are as follows: 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.

e. What are some of the practical difficulties in arranging this swap?