Reference no: EM132211692

Question - A regional bank holding company recently bought a $100 million package of mortgages that carry an average 5.5 percent yield. The holding company has established a subsidiary to manage this package. The subsidiary will finance the mortgages by selling 90-day commercial paper for which the current rate is 2.25 percent. The interest rate risk assumed by the subsidiary is evidenced by the difference in duration of the mortgages at six years and the duration of the commercial paper at 72 days. The holding company thus decides to arrange an interest rate swap through an intermediary bank to hedge the subsidiary's interest rate risk.

a. Should the subsidiary make floating-rate or fixed-rate payments in the swap market? Specifically, should the subsidiary pay fixed and receive floating, or pay floating and receive fixed? Use the following data to select specific swap terms. Explain why this swap should reduce the subsidiary's interest rate risk. Pay 5.37 percent and receive floating at three-month LIBOR Pay three-month LIBOR and receive 5.24 percent

b. At the first pricing of the swap when the subsidiary exchanges payments with the intermediary, LIBOR equals 4.95 percent. The notional principal amount is $100 million. Calculate the subsidiary's net cash payment or receipt with the intermediary. At the second pricing, LIBOR equals 5.66 percent. Calculate the subsidiary's net cash payment or receipt with the intermediary at this pricing.

c. What specific credit risk does the subsidiary assume in the swap you arranged? What specific credit risk does the intermediary assume? Discuss the interest rate environment when each party is at risk and will lose if the counterparty defaults.