Financial Markets and Institutions (2-downloads)

www.pearsonhighered.com/mishkin_eakins

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Part 7 The Management of Financial Institutions

Midwest

Savings

Bank

Fixed rate

over

10-year period

5%

⫻ $1 million

Variable rate

over

10-year period

(T-bill 

⫹ 1%) ⫻ $1 million

Pays

Receives

Friendly

Finance

Company

Receives

Pays

F I G U R E   2 4 . 2

Interest-Rate Swap Payments

In this swap arrangement, with a notional principal of $1 million and a term of 10 years,

the Midwest Savings Bank pays a fixed rate of 5% 

⫻ $1 million to the Friendly Finance

Company, which in turn agrees to pay the one-year Treasury bill rate plus 1% 

⫻ $1 million

to the Midwest Savings Bank.

Suppose that the Midwest Savings Bank, which tends to borrow short term and

then lend long term in the mortgage market, has $1 million less of rate-sensitive assets

than it has of rate-sensitive liabilities. As we learned in Chapter 23, this situation

means that as interest rates rise, the rise in the cost of funds (liabilities) is greater

than the rise in interest payments it receives on its assets, many of which are fixed

rate. The result of rising interest rates is thus a shrinking of Midwest Savings’ net

interest margin and a decline in its profitability. As we saw in Chapter 23, to avoid

this interest-rate risk, the manager of the Midwest Savings would like to convert

$1 million of its fixed-rate assets into $1 million of rate-sensitive assets, in effect mak-

ing rate-sensitive assets equal to rate-sensitive liabilities, thereby eliminating the gap.

This is exactly what happens when she engages in the interest-rate swap. By taking

$1 million of its fixed-rate income and exchanging it for $1 million of rate-sensitive

Treasury bill income, she has converted income on $1 million of fixed-rate assets into

income on $1 million of rate-sensitive assets. Now when interest rates increase, the

rise in rate-sensitive income on its assets exactly matches the rise in the rate-

sensitive cost of funds on its liabilities, leaving the net interest margin and bank prof-

itability unchanged.

The manager of the Friendly Finance Company, which issues long-term bonds to

raise funds and uses them to make short-term loans, finds that he is in exactly the

opposite situation to Midwest Savings: He has $1 million more of rate-sensitive assets

than of rate-sensitive liabilities. He is therefore concerned that a fall in interest rates,

which will result in a larger drop in income from its assets than the decline in the cost

of funds on its liabilities, will cause a decline in profits. By doing the interest-rate

swap, the manager eliminates this interest-rate risk because he has converted 

$1 million of rate-sensitive income into $1 million of fixed-rate income. Now the man-

ager of the Friendly Finance Company finds that when interest rates fall, the decline

in rate-sensitive income is smaller and so is matched by the decline in the rate-

sensitive cost of funds on its liabilities, leaving profitability unchanged.

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1

For more details and examples of how interest-rate risk can be hedged with interest-rate 

swaps, see the appendix to this chapter which can be found on the book’s Web site at