Consider a bank, its deposits represent liabilities and are most likely short-term in nature. In other words, deposits represent floating-rate liabilities. The bank assets are primarily loans. Most loans carry fixed rates of interest. The bank assets

### i. Nature of Interest Rate Risk that the Bank Faces The bank is exposed to interest rate risk primarily due to the mismatch between the interest rates on its assets (loans) and liabilities (deposits). In this case, the bank holds fixed-rate assets and floating-rate liabilities. 1. **Interest Rate Exposure**: When interest rates rise, the cost of servicing floating-rate liabilities increases, as deposit interest rates are likely to increase in response to market rates. However, the interest income from the bank’s fixed-rate loans does not increase, leading to a narrowing of the net interest margin. This means the bank may experience a decline in profitability. 2. **Earnings Sensitivity**: If the bank relies heavily on the interest income from fixed-rate loans while paying higher rates on floating-rate deposits, the bank's earnings may become more sensitive to changes in interest rates. A rise in rates may lead to higher overall costs without a corresponding increase in revenue. 3. **Market Value Risk**: In addition to the immediate impact on earnings, changes in interest rates can also affect the market value of fixed-rate assets. If interest rates increase, the market value of existing fixed-rate loans will decrease since new loans at higher rates will likely yield better returns. This can result in unrealized losses on the bank's balance sheet. ### ii. Interest Rate Swap as a Hedging Tool An interest rate swap is a financial derivative that allows two parties to exchange interest rate cash flows. Typically, one party pays a fixed interest rate while receiving a floating interest rate, and the other party pays a floating rate while receiving a fixed rate. **How an Interest Rate Swap May Be Used to Hedge Interest Rate Risk**: 1. **Creation of a Synthetic Variable Rate Asset**: The bank can enter into a receive-fixed, pay-floating interest rate swap. In this case, the bank would pay a floating rate to the counterpart in exchange for receiving a fixed rate. This effectively converts its fixed-rate income from loans into a more variable structure. 2. **Mitigating Interest Rate Risk**: By entering into this swap, the bank offset potential losses it might face from increasing interest rates on its liabilities. If interest rates rise, while the bank's income from fixed-rate loans remains unchanged, its swap payments would increase due to the higher floating rates on the liability side. However, the financial impact on the net cash flows could be more balanced as the floating payments on the swap will reflect the increased costs of deposits. 3. **Net Interest Margin Stability**: The swap helps in stabilizing the net interest margin by reducing the sensitivity of overall income to interest rate fluctuations. While the bank still faces some degree of risk, the swap helps manage and mitigate that risk by allowing the bank to align its cash flows more closely with its liabilities. 4. **Improving Risk Management**: The use of interest rate swaps can improve the bank’s risk management profile by providing more certainty around cash flows, allowing for better financial planning and capital allocation. Overall, through the strategic use of interest rate swaps, banks can effectively modulate the risks associated with mismatched interest rate exposures and maintain stability in their earnings and capital positions amidst changing market interest rates.