An insurance company owns RM50 million of floating-rate bonds yielding LIBOR plus 1 percent. These loans are financed by RM 50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. A finance company has RM 50 million of auto loans with a fixed rate of 14 percent. The loans are financed by RM 50 million of CDs at a variable rate of LIBOR plus 4 percent.

a) What is the risk exposure of the insurance and finance company?

(b)Propose a mutually beneficial swap. Illustrate the proposed swap in diagram.

(c) In a swap arrangement, the variable-rate swap cash flow streams often do not fully hedge the variable-rate cash flow streams from the balance sheet due to basis risk. What are the possible sources of basis risk in an interest rate swap?

(c) What is maturity intermediation? Comment some of the ways in which the risks of maturity intermediation could be managed by financial intermediaries?