Question

A bank currently holds a loan with a principal of $12 million. The loan generates quarterly interest payments at a rate of LIBOR plus 300 basis points, with the payments made on the 15th of february, may, august and november on the basis of the actual day count divided by 360. The bank has begun to believe that interest rates will fall. It would like to use a swap to synthetically alter the payments on the loan it holds. The rate it could obtain on a plain vanilla swap is 7.25 percent. Explain how the bank would use a swap to achieve this objective.

Answer 1

The bank can use a plain vanilla interest rate swap to synthetically alter the interest payments on the loan it holds and hedge against potential interest rate declines. By entering into a swap agreement, the bank would receive fixed interest payments, while paying out variable interest payments based on the LIBOR rate plus 300 basis points. This helps the bank lock in a fixed interest rate and reduce interest rate risk.

Step-by-step explanation:

The bank can use a plain vanilla interest rate swap to achieve its objective. In this case, the bank would enter into a swap agreement with another party, typically a financial institution or another bank. The bank would pay the counterparty a fixed interest rate of 7.25 percent on the notional amount of the swap, which is $12 million in this case. In return, the counterparty would pay the bank a variable interest rate based on the LIBOR rate plus 300 basis points.

By entering into this swap agreement, the bank effectively synthetically alters the interest payments on the loan it holds. Instead of receiving variable interest payments based on the LIBOR rate plus 300 basis points, the bank now receives fixed interest payments of 7.25 percent. This allows the bank to hedge against the potential decline in interest rates and lock in a fixed interest rate.

For example, if the LIBOR rate falls to 2 percent, the bank would still receive fixed interest payments of 7.25 percent from the counterparty, while paying out variable interest payments of 2 percent. This effectively reduces the bank's interest rate risk and provides certainty in its cash flows.