THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 403

CHAPTER 14 Interest-Rate Swap Contracts Risk Management with Financial Derivatives 371 Interest-rate swaps are an important tool for managing interest-rate risk, and they first appeared in the United States in 1982 when there was an increase in the demand for financial instruments that could be used to reduce interest-rate risk The most common type of interest-rate swap (called the plain vanilla swap) specifies (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges continue to be made There are many other more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap Figure 14-4 illustrates an interest-rate swap between First Trust and the Friendly Finance Company First Trust agrees to pay Friendly Finance a fixed rate of 7% on $1 million of notional principal for the next ten years, and Friendly Finance agrees to pay First Trust the one-year treasury bill rate plus 1% on $1 million of notional principal for the same period Thus, as shown in Figure 14-4, every year First Trust would be paying the Friendly Finance Company 7% on $1 million while Friendly Finance would be paying First Trust the one-year T-bill rate plus 1% on $1 million Pays First Trust Receives F I G U R E 14 - Fixed rate over ten-year period 7% $1 million Variable rate over ten-year period (T-bill 1%) $1 million Receives Friendly Finance Company Pays Interest-Rate Swap Payments In this swap arrangement, with a notional principal of $1 million and a term of ten years, First Trust pays a fixed rate of 7% $1 million to the Friendly Finance Company, which in turn agrees to pay the one-year treasury bill rate plus 1% $1 million to First Trust A PP LI CATI O N Hedging with Interest-Rate Swaps You might wonder why the managers of the two financial institutions find it advantageous to enter into this swap agreement The answer is that it may help both of them hedge interest-rate risk Suppose that First Trust, which tends to borrow short-term and then lend longterm in the mortgage market, has $1 million less of rate-sensitive assets than it has of rate-sensitive liabilities As we learned in Chapter 13, this situation means that as interest rates rise, the rise in the cost of funds (liabilities) is greater than the rise in interest payments it receives on its assets, many of which are fixed-rate The result of rising interest rates is thus a shrinking of First Trust s net interest margin and a decline in its profitability As we saw in Chapter 13, to avoid this interest-rate risk,