In: Finance
A commercial bank calculates that the duration of its liabilities (excluding net worth) averages one year while the duration of its assets averages 5 years. Assume that this bank has USD100mn of assets and USD25mn of capital. Also assume that assets and liabilities (excluding net worth) are interest rate sensitive and enter the balance sheet at market value (marked to market). If interest rates rose by 200bp what would be the impact on this bank’s leverage ratio? if the bank had wanted to neutralise (immunise) the balance sheet impact of any interest rate shifts through the futures market, what would be the best strategy?
A. Buy 1200 Treasury Bond futures contracts
B. Sell 1700 3mth Eurodollar futures contracts
C. Buy 850 3mth Eurodollar futures contracts
D. Sell 1250 6mth Euroyen futures contracts
Bank liability = Capital - Assets = $100M - $25M = $75M
If interest rate rises by 2%, the impact on bank assets and liabilities will be:
Bank asset will decrease by = 2%*5*100 = $10M
Bank liabilities will decrease by = 2%*1*75 = $1.5M
Computation of Leverage ratio
Leverage ratio = Total Capital / Total assets
Leverage ratio before change in rates = 25 / 100 = 25%
Leverage ratio after change in rates = (25 +1.5) / (100 -10) = .29.44%
Hence, if interest rate rises by 2%, then the bank's leverage ratio will also increase from 25% to 29.44%.
Best strategy to minimise balance sheet impact of any interest rate shifts through the futures market
The bank should buy interest rate future. As it has higher duration for assets therefore to protect from fall in value due to rise in interest rates, it should take long position in interest rate future.
Hence, the bank should Buy 850 3mth Eurodollar futures contracts.