two institutions plan to issue $10 million in debt and are negotiating an interest rate swap that will help them lower there borrowing costs and obtain the preferred type (fixed rate or floating rate) of financing. Both are comparing their balance sheet alternatives with combined balance sheet and swap oportunities. Internet Bank has a negative GAP through three years, is liability sensitive, and would like to use the debt proceeds to invest in short term assets to reduce its interest rate risk.Brick & Mortar Bank has a positive GAP through three years, is asset sensitive, and would like to use its debt proceeds to invest in fixed rate assets to reduce its interest rate risk.Internet Bank can borrow at a 4.7% fixed rate for three years or pay the prevailing six month LIBOR plus 1 percent on floating rate debt. Brick & Mortar Bank can borrow at a 4.15% fixed rate for three years or the prevailing six month LIBOR plus 0.50 percent.

a. Explain whether and why Internet Bank needs fixed rate or floating rate funding to meet its objectives. do the same for Brick & Mortar Bank.

b. Assume that both banks issue either three year fixed rate debt or 6 month floating-rate debt on-balance sheet. They want to combine this with a basic swap to obtain the cheapest form of funding that helps reduce interest rate risk. Using the following basic swap terms, indicate what position each bank should take.Explain how and why it should meet the bank's objectives. Calculate the effective cost of borrowing that each bank ends up with.

Basic Swap Terms

A. Pay 5.10%	Receive 6 month LIBOR
B. Pay 6 month LIBOR	Recieve 5.06%

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