What risks do the finance house and bank face, Corporate Finance

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Question :

a) What are the rationales for interest and currency swaps?

b) A finance house and a bank each have a $1billion balance sheet. The finance house has lent out at a fixed rate of 22% pa for five years. The loans are interest only with a bullet repayment of the capital on maturity. It has financed them by the issue of certificates of deposit, paying the T-Bill rate plus 60 basis points.

The bank has access to savings deposits at a fixed rate of 4%. It has lent out these funds on a floating rate basis at the T-Bill rate plus 220 basis points.

All floating rates are reset each quarter and fixed rate payments are made at the same time. The 3-month T-Bill rate is initially 6%.

a) What are the spreads on which the finance house and the bank operate?

b) What risks do the bank face and finance house?

c) Prepare a swap that will immunise both spreads. Describe how it works and why it might be preferred to a policy of matching.


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