Question

Consider the above figure for the questions that follow. It shows. 1. a commercial that pays a variable rate to hold purchase money that supports a long term commercial mortgage portfolio, 2. a life insurance company that owns a variable rate bond portfolio to support life insurance policies, 3. two swaps with a dealer that reduce interest rate risk for both the insurance company and the commercial bank. Cash Flows from Fixed to Floating Interest Rate Swap Commercial Mortgages Fored Indemnity to Policy Holders Swap Dealer Commercial Life Insurance Company > Swap Clearing House Variable Rate Bond Portfolio Purchase Money (Deposits) Life Insurance Company Pays (choose one) Floating (Variable) or Fixed Receives (choose one) Floating (Variable) or Fixed Commercial Bank Pays (choose one) Floating (Variable) or Fixed Receives (choose one) Floating (Variable) or Fixed

Consider the image above involving swaps between a commercial bank, a life insurance company and a swap dealer. The letter "A" represents,

Options:

a.	Floating rate cash flows
b.	Fixed rate Cash Flow

The life insurance company will (choose two)

Options:

a.	Pay fixed cash flows to the swap dealer.
b.	Pay floating Cash Flows to the swap dealer.
c.	Receive fixed cash flows from the swap dealer.
d.	Receive floating cash flows from the swap dealer.

The commercial bank will (choose two)

Options:

a.	Pay fixed cash flows to the swap dealer.
b.	Pay floating Cash Flows to the swap dealer.
c.	Receive fixed cash flows from the swap dealer.
d.	Receive floating cash flows from the swap dealer.

Answer 1

There are three parties discussed in the question:

a) Commercial Bank

b) Life Insurance Company

c) Swap dealer

Let us first discuss the Life Insurance Company,

The insurance company has to pay fixed indemnity to its policyholders. Therefore, its outflows are fixed.

Also, the company has a portfolio of bonds which pays variable (floating) interest rate. Therefore, its inflows are variable.

This can impact the company negatively in case interest rate goes down in the market since variable inflow (from bonds) will reduce and may not be enough to honor the fixed outflow (to policyholders)

Therefore, to reduce risk the company will swap his variable income cash flow with the swap dealer to get fixed cash flow.

Refer to the diagram below:

I Fixed Indemnity to Policy holders Fixed Swap Dealers Insurance Company Swap Clearing Mouse Floating A Floating Variable rate Bond Portfolio

Now lets discuss the commercial bank,

The commercial bank has to pay variable interest rate (also known as floating interest rate) to the depositors to purchase money from them. Therefore, its outflows are variable.

Also, he has a mortgage portfolio as an asset on which it is charging a fixed interest rate. Therefore, its inflows are fixed.

This can impact the bank negatively in case interest rate goes up in the market since fixed inflow (from mortgage) may not be enough to honor the increased variable outflow (to depositors)

Therefore, to reduce risk the bank will swap his fixed income cash flow with the swap dealer to get floating rate cash flow.

Refer to the diagram below:

Commercial Mootgages Fixed B Swap Dealer or Swap Clearing House Commonial Bank Floating Floating Purchase Money (Deposits)

Combining the above explanations we can now make the complete diagram as below :

Fixed Indemnity to Bolicy holders Commercial Mootgages Fixed B To Fixed Fixed в Bited с k Swap Dealer | Swap Clearing Commonial Bank Insurance Company House Floating Floating A Floating Floating Purchase Money (Deposits) Variable date Bond Portfolio

Therefore, the answers to the questions asked are as follows:

1. Letter A represents "Floating rate cash flows" (Option a)

2. The life insurance company will

b) Pay floating Cash Flows to the swap dealer

c) Receive fixed cash flows from the swap dealer

3. The commercial bank will

a) Pay fixed cash flows to the swap dealer

d) Receive floating cash flows from the swap dealer.