Question

1. Describe the interest-rate risk exposure of a bank that in March 2019 made a two-year $100m term loan with funds raised by 90-day NCDs.

2. Explain how the bank can use futures to hedge this risk, nominating with futures position would be involved

Make answers simple! Thank you very much !

Answer 1

(1). INTREST-RATE-EXPOSURE

1 Income Gap: Definition and Measurement We use the definition of the income gap of a financial institution in Mishkin and Eakins (2009):

Income Gap = RSA − RSL

• (1) where RSA is a measure of the number of assets that either reprice, or mature, within one year, and RSL the amount of the liabilities that mature or reprice within a year. RSA (RSL) is the number of dollars of assets (liability) that will pay (cost) variable interest rate. Hence, the income gap measures the extent to which a bank’s net interest income is sensitive to interest rates changes. Because the income gap is a measure of exposure to interest rate risk, Mishkin and Eakins (2009) propose to assess the impact of a potential change in short rates ∆r on bank income by calculating: Income Gap × ∆r

Direct evidence on Interest Rate Risk Hedging

• In this section, we ask whether banks use derivatives to neutralize their “natural” exposure to interest rate risk. We can check this directly in the data. The schedule HC-L of the form FR Y9C reports, starting in 1995, the notional amounts in interest derivatives contracted by banks. Five kinds of derivative contracts are separately reported: Futures (bhck8693), Forwards (bhck8697), Written options that are exchange-traded (bhck8701), Purchased options that are exchange-traded (bhck8705), Written options traded over the counter (bhck8709), Purchased options traded over the counter (bhck8713), and Swaps (bhck3450)  

and also NCDs shall not be issued for maturities of less than 90 days from the date of issue. The maturity date of the NCD shall co-terminate with the date up to which the credit rating of the issuer is valid.

Bank profits are exposed to interest rates movements. The gap between the interest rate sensitivities of assets and liabilities is called the “income gap”: it measures the extent to which banking profits respond to monetary policy tightening

(2). Banks often hedge against interest rate risk using only interest rate futures contracts or foreign exchange risk of a particular currency one at a time using only the corresponding currency forward contract, thus separating the management of interest rate risk from foreign exchange risk.

• Single direct hedge outperforms the composite hedge in reducing foreign exchange risk for banks that manage interest rate risk separately from foreign exchange risk.
• The integrated hedge of both interest rate and foreign exchange risk with a single instrument of interest rate futures effectively outperforms the corresponding hedge with composite instruments in terms of reducing risks.
• Integrated hedge with currency forwards alone shows the poorest hedging effectiveness.