Assume that the United States just experienced a mild recession. As a result, interest rates have declined to their lowest levels in a decade. The U.S. interest rates appear to be influenced more by changes in the demand for funds than by changes in the supply of U.S. savings, because the savings rate does not change much regardless of economic conditions. The yield curve is currently flat. The federal budget deficit has improved lately and is not expected to rise substantially.
The federal government recently decided to reduce personal tax rates significantly for all tax brackets as well as corporate tax rates. The U.S. dollar has just recently weakened. Economies of other countries were somewhat stagnant but have improved in the past quarter. Your assignment is to recommend how various financial institutions should respond to the preceding information.
A savings institution holds 50 percent of its assets as long-term fixed-rate mortgages. Virtually all of its funds are in the form of short-term deposits. Which of the following strategies would be most appropriate for this institution?
• Use a fixed-for-floating swap.
• Use a swap of floating payments for fixed payments.
• Use a put option on interest rate futures contracts.
• Remain unhedged.
Defend your recommendation.