The Bank of Orlando has large holding of 8% fixed-rate loans. The bank's sources of funds cost on average LIBOR - 1%.
a) If LIBOR is currently at 5%, what spread is the bank earning?
b) If LIBOR increases to 7%, what is the new spread the bank is earning?
c) Assuming the bank decides to enter into an interest rate swap that allows the bank to receive LIBOR in exchange for paying a rate of 5% fixed, what is the spread now locked in at?
Show you calculations.
Net Interest Rate Spread
The net interest rate spread is the difference between the interest yield that a bank receives on its loan and the average rate it pays on its deposits and borrowings. Higher the rate spread, higher is the profitability of a financial institution.
Answer and Explanation:
Rate of interest on Bank of Orlando's fixed rate loan = 8%
Cost of funds for the bank = LIBOR - 1%
Net Interest Spread for the Bank = Yield on fixed-rate loans - Cost of funds for the bank
a) When LIBOR is at 5%, the cost of funds for the bank is 5% - 1% or 4%. Therefore the bank earns a spread of 8% - 4% = 4%.
b) When LIBOR increases to 7%, the cost of funds for the bank is 7% - 1% = 6%. Therefore the bank earns a spread of 8% - 6% = 2%.
c) When bank enters into an interest rate swap which allows the bank to receive LIBOR in exchange for paying a rate of 5% fixed, the spread which is locked is calculated as below:
Bank receives 8% on fixed rate loan and receives LIBOR in interest rate swap. So bank earns LIBOR + 8%
Bank pays LIBOR - 1% for cost of funds and also pays 5% in interest rate swap. So bank pays LIBOR + 5% - 1% = LIBOR + 4%
Net Interest spread locked = LIBOR + 8% - LIBOR - 4% = 4%. Therefore, the bank is able to lock a spread of 4% under this arrangement.
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from Chartered Financial Analyst (CFA): Exam Prep & Study GuideChapter 9 / Lesson 9