Question

1.

A given bank has the following interest‐sensitive assets and liabilities on its balance sheet (in $ millions). If the interest rate rises by 1.5%, what is the change of profit?

Interest rate sensitive assets Interest rate sensitive liabilities

Short term securities $150 Deposits $659

Loans $575

2 Based on the answer to the previous question, should the bank be concerned about a decrease in interest rates?

No. Decrease is favorable to the bank because it has a negative interest rate gap.

Yes. Decrease is unfavorable to the bank because it has a negative financing gap.

No. Decrease is favorable to the bank because it has a positive financing gap.

Yes. Decrease is favorable to the bank because it has a positive financing gap.

3 If a bank wanted to hedge against a change in interest rates, what could it do?

It could be a counterparty in an interest rate swap.

It could purchase interest rate options.

It could open a interest rate futures position.

All of the above.

Only a and c above.

Answer 1

1) Change in Profit if interest Rates increase by 1.5 %

Change in Profit	USD millions
Assets
Short Term Securities	$150.00
loans	$575.00
Less Liabilities
Deposits	-$659.00
Interest Rate Gap	$66.00
Increase in Interest Rate	1.50%
Additional Income (66*1.5%)	$0.99

2)

Based on the answer to the previous question, should the bank be concerned about a decrease in interest rates?
Answer

Yes. Decrease is unfavorable to the bank because it has a positive financing gap.

A positive gap means, interest rate bearing assets exceed interest rate liabilities.(given case there is positive gap of $66M)
When interest rate rise, the bank benefits, however when interest rates decrease there is an adverse effect on profits.

3) If a bank wanted to hedge against a change in interest rates, what could it do?

• It could be a counterparty in an interest rate swap.
• It could purchase interest rate options.
• It could open a interest rate futures position.
• All of the above.
• Only a and c above.

Answer: All of the above.
SWAP: The bank could enter a Interest Rate Swap transaction, where it receives Fixed Interest Rate payments and Pays floating rate transactions. If the bank expects the interest rate to decrease, the fixed leg of Swap would earn higher receipts, while floating leg of Swap there would be reduced payments in floating leg. Hence there would be a net gain in the swap transaction.

Interest Rate Option.
In this transaction, bank can enter a interest rate put option, it would give the bank the right and not obligation to benefit from decreasing interest rates. If the prevailing interest rate falls below strike price, the bank would gain in the option transaction, subject to premium payments made.

Interest Rate Future Transaction

An Interest rate futures (IRF) contract enables the buyer of the contract to lock in a future investment Rate. Price of interest rate future and interest rates are inversely related, if the interest rate fall, the price of of interest future increases. therefore the bank should have a long position in interest rate future if it expects interest rate to fall in future.