Question

A bank has issued a one- year certificate of deposit for $50 million at an interest rate of 2 percent. With the proceeds, the bank has purchased a two- year Treasury note that pays 4 percent interest. a) What is the Bank's asset? b) What is the Bank's liability? c) What risk does the bank face in entering into these transactions? d) What would happen if all interest rates were to rise by 1 percent? Will the bank earn or lose money?

Answer 1

a.

Asset = $50 million

The amount of Treasury note of $50 million is asset, since the money has been invested there.

b.

Liability: $50 million

The amount of certificate of deposit (CD) of $50 million is liability, since the bank has obligation of returning that money to the depositor at maturity.

c.

Answer: liquidity of the bank at the maturity of CD would be a risk.

Once there is an issue of CD, this has to be repaid together with interest at maturity; therefore, the bank has payment obligation after 1 year. This is backed by the T-note, which gives high degree of safety of getting returns; but this is blocked for 2 years; therefore, the bank has to arrange ($50 million × (1 + 0.02) = 50 × 1.02 =) $51 million internally after 1 year to repay the CD, which could be a risk.

d.

The interest rate of CD becomes (2 + 1 =) 3%

The interest rate of T-notes becomes (4 + 1 =) 5%

The bank will earn money, since the interest of T-note is higher than the interest of CD.