a. Determine the spread that would be earned each year if Stetson uses an interest rate swap to hedge all of its interest rate risk. Would you recommend that Stetson use an interest rate swap?

b. Although Stetson has forecasted its cost of funds, it recognizes that its forecasts may be inaccurate. Offer a method that Stetson can use to assess the potential results from using an interest rate swap while accounting for the uncertainty surrounding future interest rates.

c. The reason for Stetson's interest rate risk is that it uses some of its funds to make fixed-rate loans, as some borrowers prefer fixed rates. An alternative method of hedging interest rate risk is to use adjustable-rate loans. Would you recommend that Stetson use only adjustable-rate loans to hedge its interest rate risk? Explain.

As a manager of Stetson Bank, you are responsible for hedging Stetson's interest rate risk. Stetson has forecasted its cost of funds as follows:

Year ___________________________Cost of Funds

1.............................................6%

2.............................................5%

3.............................................7%

4.............................................9%

5.............................................7%

It expects to earn an average rate of 11 percent on some assets that charge a fixed interest rate over the next five years. It considers engaging in an interest rate swap in which it would swap fixed payments of 10 percent in exchange for variable-rate payments of LIBOR + 1 percent. Assume LIBOR is expected to be consistently 1 percent above Stetson's cost of funds.