QUESTION 3[15 Marks]

Use this balance sheet information to answer the following questions:

Financial Institution (FI) Balance Sheet (Amount in millions, Duration in years)
Assets	Amount	Duration	Liabilities	Amount	Duration
Cash	350		Core Deposits	1250	0.75 yrs
Treasury Bonds	450	1.95 yrs	CDs	750	1.25 yrs
Loans (special)	950		Euro CDs		1.25 yrs
Loans (variable)	950		Debentures	1500	2.75 yrs
			New Debenture Issue	600
Loans (fixed)	2500	3.05 yrs	Equity	350

The variable loans are repriced every 180 days.

The bank is considering approving a special loan with the following characteristics:

The loan has repayments of $129.1 at the end of year 1, $575.1 at the end of year 4, $285.1 at the end of year 5 and $150.3 at the end of year 6.

The loan is tradingapproximately at par and the yield to maturity is 4.5 percent per annum.

The bank is also considering issuing 600,000 debentures with 4.5% coupon rate and a maturity of 10 year, with a face value of $1,000. At the time of issue, the debenture was trading at par. Assume the debentures pay the coupons annually.

The yield curve is flat, and the interest rate is 4.5%. The financial institution decides to use a 3-year swap. The swap is composed of a three-year bond with a fixed coupon rate of 4.5 percent paid annually and a floating-rate bond with duration of approximately zero.

Using this swap, determine the notional principal of the swap and advise the financial institution on whether it should be a fixed or floating payer. Present an explanation including pertinent assumptions of how the swap you have recommended works.