Question

NatWest like virtually all financial institutions has as a key focus, asset and liability management. They wish to ensure that there is an adequate spread between return on assets and the cost of funds, liabilities. They are also concerned with the interest rate sensitivity of assets and liabilities as well as their respective liquidity. A key asset for NatWest is in the form of 30-year mortgages with floating interest rates that adjust on an annual basis. NatWest obtains most of its funds by issuing 5-year Certificates of Deposit. It uses the Yield Curve to assess the market’s anticipation of future interest rates. It believes that expectations of future interest rates are the main driver of affecting the Yield Curve. Assume that the Yield Curve is steeply downward sloping. Based upon the information provided and your understanding of what drives their business model, please answer the following questions:

a. Why is it important to assess the sensitivity of assets and liabilities in a financial institution such as NatWest?

b. If the time-weighted value of assets is not the same as that of liabilities, in

effect, what is the financial institution doing and explain why this may or may not be OK.

c. What do we mean by Liquidity Matching and why should this be important to an

institution such as NatWest?

d. Do you think NatWest should use financial futures as a method of hedging? Why or why not.

Answer 1

A. For Natwest, there is a huge duration gap between its assets and liabilities as the assets are 30year mortgages and liabilities are 5 year Certificate of deposits which makes it necessary for the firm to analyze the sensitivity of both their assets and liabilities to interest rates so that they do not face a crunch making it difficult for them to repay their liabilities (as their assets duration is longer and not liquid enough for them to help them repay their liabilities).

B. Here the time weighted value of assets and liabilities I.e the duration of assets and liabilities are not same (assets 30 year and liabilities 5  years). Thus the firm should be doing a duration matching for interest rate sensitivity management to analyze and keep track of their interest rate risk.

C. There is a huge liquidity gap between assets and liabilities for Natwest, assets mature in 30 years and liabilities in 5 years making it difficult for Natwest to find sufficient funds every 5 years for the repayment of liabilities when their assets can be liquidated only after 30 years. Thus a proper liquidity matching system should be in place to avoid any liquidity crunches.

D. Futures as a derivative instrument can be used to fix any particular rate or exchange rate or purchase price bringing in more certainty for the firm who is looking for hedging and decreasing risk. Here, Natwest has a duration gap and the yield curve is downward sloping signaling a fall in interest rates and recessionary environment at least for the next 5 years. Thus as the interest rates are appearing to be falling, hedging using a future and thus fixing a interest rate would be unnecessary and also decreasing the possibility of using the fall the interest rates. Thus to make the most of a falling interest rate environment, its better not to hedge using a future