Suppose that Polestar 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, Polestar and Emblem bank come to an agreement of a swap arrangement, whereby Emblem receives fixed-rate payments from Polestar's mortgages, equaling 9%. In exchange, Polestar receives variable payments from Emblem, equaling the LIBOR rate (the interbank lending rate for Eurobanks). Assume that Polestar's cost of funds (or the rate owed on its deposits) is equal to the LIBOR rate, less 1%. A The following table details the swap arrangement from the point of view of Polestar bank for various possible values of LIBOR. 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 7% 11% 6 5 11% 9 2 7 6 Possible Future LIBOR Rates 8% 9% 10% 11% 11% 11% 11% 11% 7 4 11% 9 2 8 7 8 3 2 9 11% 11% 9 9 2 9 8 2 10 9 10 1 11% 9 2 IN 11 10 12% 11% 11 0 11% 9 2 12 11 Spread on variable-rate payments Combined total spread when using swap 1 3 1 3 1 3 1 3 1 3 1 3 If LIBOR is 7%, Polestar's spread would be If LIBOR is 10%, Polestar's spread would be when LIBOR is 10%. % if unhedged and % if unhedged, and % when hedged. Thus, hedging leads to a % when hedged. Thus, hedging leads to higher lower spread. spread