1 answer

Should Financial Institutions Engage in Interest Rate Swaps for Speculative Purposes? Credit default swaps were once...

Question:

  1. Should Financial Institutions Engage in Interest Rate Swaps for Speculative Purposes?
  2. Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Yet, the swaps were sometimes criticized for making the credit crisis worse. Why?
  3. Miami Mutual Bank* purchases a two-year interest rate cap for a fee of 3 percent of notional principal valued at $10 million, with an interest rate ceiling of 11 percent and LIBOR as the index representing the market interest rate. At the same time, Miami Mutual sells a two-year floor (8 percent) for a fee of 2 percent of the $10 million principal. Assume that LIBOR is expected to be 7 percent and 14 percent at the end of each of the next two years, respectively. What is this type of strategy called? Also what dollar amount do Miami Mutual Bank stand to gain or lose from this strategy?


    *Fun fact why did Leonardo DiCaprio visit this bank in 2002?

Answers

There are two reasons why companies may want to engage in interest rate swaps for Speculative Purposes:

1. Commercial motivations. Some companies are in businesses with specific financing requirements, and interest rate swaps can help managers meet their goals. Two common types of businesses that benefit from interest rate swaps are:

(a)Banks, which need to have their revenue streams match their liabilities. For example, if a bank is paying a floating rate on its liabilities but receives a fixed payment on the loans it paid out, it may face significant risks if the floating rate liabilities increase significantly.

As a result, the bank may choose to hedge against this risk by swapping the fixed payments it receives from their loans for a floating rate payment that is higher than the floating rate payment it needs to pay out. Effectively, this bank will have guaranteed that its revenue will be greater than it expenses and therefore will not find itself in a cash flow crunch.

(b)Hedge funds, which rely on speculation and can cut some risk without losing too much potential reward. More specifically, a speculative hedge fund with an expertise in forecasting future interest rates may be able to make huge profits by engaging in high-volume, high-rate swaps.

2. Comparative advantages: Companies can sometimes receive either a fixed- or floating-rate loan at a better rate than most other borrowers. However, that may not be the kind of financing they are looking for in a particular situation.

A company may, for example, have access to a loan with a 5% rate when the current rate is about 6%. But they may need a loan that charges a floating rate payment. If another company, meanwhile, can gain from receiving a floating rate interest loan, but is required to take a loan that obligates them to make fixed payments, then two companies could conduct a swap, where they would both be able to fulfill their respective preferences.

In short, the swap lets banks, investment funds, and companies capitalize on a wide range of loan types without breaking rules and requirements about their assets and liabilities.

Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Yet, the swaps were sometimes criticized for making the credit crisis worse because:

1. Swaps were unregulated until 2009.

That meant there was no government agency to make sure the seller of the swap had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted.

2. Unfortunately, the swaps gave a false sense of security to bond purchasers.

They bought riskier and riskier debt. They thought the CDS protected them from any losses.

This strategy is called interest rate collar is an investment strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations. An interest rate collar protects a borrower against rising interest rates while setting a floor on declining interest rates.

Fun Fact:

In Catch Me If You Can, Union Station stands in for Miami Mutual Bank, in the scene where Leonardo DiCaprio’s Frank Abagnale Jr. memorably seduces a bank teller played by Elizabeth Banks.

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