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solution

An insurance company owns $50 million of floating-rate bonds yielding LIBOR plus 1 percent. These loans are financed with $50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. A bank has $50 million of auto loans with a fixed rate of 14 percent. The loans are financed with $50 million in CDs at a variable rate of LIBOR plus 4 percent.

a. What is the risk exposure of the insurance company?

b. What is the risk exposure of the bank?

c. What would be the cash flow goals of each company if they were to enter into a swap arrangement?

d. Which FI would be the buyer and which FI would be the seller in the swap?

e. Diagram the direction of the relevant cash flows for the swap arrangement.

f. What are reasonable cash flow amounts, or relative interest rates, for each of the payment streams?

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