1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 9 9 Using Swaps and Other Asset-Liability Management Techniques The purpose of this chapter is to explore the ways that swap contracts and selected other asset-liability management techniques can be used to eliminate or at least reduce a bank’s potential exposure to the risk of loss as market conditions change. We will also discover how swap contracts and other hedging tools can generate additional revenues for banks by providing risk-hedging services to their customers.

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest- Rate Risk

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Quality Swap Borrower with Lower Credit Rating Pays Fixed Payments of Borrower with Higher Credit Rating Borrower with Higher Credit Rating Pays Short-Term Floating Rate Payments of Borrower with Lower Credit Rating

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Risks of Interest Rate Swaps Substantial Brokerage Fees Credit Risk Basis Risk Interest Rate Risk

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Netting The Swap Parties Only Swap the Net Difference Between the Interest Payments. This Reduces the Potential Damage if One Party Defaults on its Obligation

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Currency Swap An Agreement Between Two Parties, Each Owing Funds to Other Contractors Denominated in Different Currencies, to Exchange the Needed Currencies with Each Other and Honor Their Respective Contracts.

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rate Cap Protects the Holder from Rising Interest Rates. For an Up Front Fee Borrowers are Assured Their Loan Rate Will Not Rise Above the Cap Rate

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rate Collar A Contract Setting the Maximum and Minimum Interest Rates That May Be Assessed on a Flexible-Rate Loan. It Combines an Interest Rate Cap and Floor into One Contract.