Question

1.Describe the two different ways in which an ADI may be exposed to interest rate risk.  What would it do – in respect of the two different aspects of interest rate risk – if it thought interest rates were going to increase in the near future and wanted to take advantage of this prediction?  Explain how these actions will be of benefit if interest rates do increase as predicted?

2.Describe how a bank could use derivatives to hedge an exposure to decreasing interest rates.

Answer 1

Answer1: Out of various ways, we are discussing following 2 ways in which an ADI may be exposed to interest rate risk:

The most simplest way is via repricing risk. Interest earned on assets and paid on liabilities(like time deposits) can change significantly due to change in interest rate as part of differences in the repricing characteristics of various types of assets and liabilities.

Another very popular way is embedded optionality.This is generally a retail banking product feature which gives the customers a flexibility of altering the cash flows of various banking products in combating adverse interest rate change.So, the impact showing on amount of interest rate risk in which ADI is exposed.

If it is being predicted that interest rate would go up in the near future ADIs can do following activities to take advantange of this prediction:

a. They should start minimiing their bond portfolio exposure.

b. They might encourage customers for more variable loan products instead of fixed interest rate product.

c. They might offer competitive deposit rate for immediate or shorter term deposits and lesser rate for long term deposits.

These above actions would benefit them significantly if interest rates do increase as predicted as

In the rising interest rate scenario, bond portfolio tends to lose more value. Taking alternative position in prior hand would benefit ADIs. With large variable loan products,core loending margins would widen for them as the gap between interest charges by them and paid for funding would increase significanly. As ADIs would offer lesser interest rate for long term deposit products, their fund borrowing cost would not be impacted much if not improved also. So, all these give cumulative positive effects in ADIs earning in interest rate increase scenario.

Answer2: Banks can use interest rate future as an effective derivatives for hedging in decreasing interest rate scenario.

Banks can buy future contracts like interest rate future at reatively low price in the spot market and can sell them when the future contracts will be priced high in falling interest rate scenario. So, in the falling interest rate scenario banks will earn lesser interest from their various loan products. Those losses can be offset by the gain earned by selling the future products.