Question

11. The Florida Investors Bank raised $300 million for four years at a fixed interest rate of 6% and then loaned the funds to Energy Associates of Fort Lauderdale Inc. The loan calls for an interest rate that varies every year. The interest rate that Energy Associates of Fort Lauderdale agreed to pay is LIBOR plus 300 basis points. At the same time, Florida Investors Bank entered into a four-year interest rate swap with an investment banking firm, Morgan Stanley, with a notional amount of $300 million. The swap terms are as follows: every year Morgan Stanley pays Florida Investors Bank 6.3%, and every year Florida Investors Bank pays Morgan Stanley LIBOR plus 50 basis points.

a. What is the risk that Florida Investors Bank faces if it does not enter into the interest rate swap?

b. Suppose that LIBOR at a payment date is 2%. What is the interest rate spread that Florida Investors Bank would realize?

c. What did Florida Investors Bank accomplish by entering into this interest rate swap

Answer 1

1)

If the Florida investors bank doesn't enter into swap agreement then it is facing interest rate risk. As it is receiving interest from Energy associates at LIBOR + 3% and paying interest at 6%. This shows that there is risk of receiving less interest in case the LIBOR falls in future.

2)

If LIBOR is 2%

Then the Florida investors bank will pay 6% and will receive 5% (2% + 3%). Interest rate spread for Bank is -1% (loss of 1% in interest)

3)

By entering into this swap agreement, the Florida investors bank is fixing its interest income at particular %

Total receipts :

From Energy associates - LIBOR + 3%

From Morgan and Stanley - 6.3%

Total payments :

To Outsiders - 6%

To Morgan and Stanley - LIBOR + 0.5%

If we net off all these receipts and payments, then we will have 2.8% of $300 million as excess receipts after paying interest obligations