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APPLICATION. Hedging with Interest-Rate Swaps

You might wonder why these two parties find it advantageous to enter into this swap agreement. The answer is that it may help both of them hedge interest-rate risk.

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 9, this situation means that as interest rates rise, the increase in the cost of funds (liabilities) is greater than the increase 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 9, to avoid this interest-rate risk, Midwest Savings would like to convert $1 million of its fixed-rate assets into $1 million of rate-sensitive assets, in effect making rate-sensitive assets equal rate-sensitive liabilities, thereby eliminating the gap. This is exactly what happens when it 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, it has converted income on $1 million of fixed-rate assets into income on $1 million of rate-sensitive assets. Now when interest rates rise, the increase in rate-sensitive income on its assets exactly matches the increase in the rate-sensitive cost of funds on its liabilities, leaving the net interest margin and bank profitability unchanged.

The Friendly Finance Company, which issues long-term bonds to raise funds and uses them to make short-term loans, finds that it is in exactly the opposite situation to Midwest Savings: It has $1 million more of rate-sensitive assets than of rate-sensitive liabilities. It 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, it eliminates this interest-rate risk because it has converted $1 million of rate-sensitive income into $1 million of fixed-rate income. Now 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 its profitability unchanged.

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