Problem:

Bank A has $100 million of mortgages with an adjustable rate of HIBOR + 2%. These assets are financed with $100 million of fixed-rate deposits costing 5%. Bank B has $100 million investment of fixed-income notes with a fixed rate of 7%, which are financed with $100 million in CDs with a variable rate of HIBOR + 1%.

Required:

Question 1: Discuss the particular interest rate risk each bank faces.

Question 2: Assuming equal negotiation power, propose a feasible interest rate swap and demonstrate how such a swap may help both banks from hedging their interest rate risk in question by computation of the net position and net funding cost for each bank as a result of the proposed swap.

Note: Explain all steps comprehensively.