Question

As a consultant to Boca Savings & Loan Association, you notice that a large portion of its 15-year, fixed-rate mortgages are financed with funds from short-term deposits. You believe the yield curve is useful in indicating the market’s anticipation of future interest rates and that the yield curve is primarily determined by interest rate expectations. At the present time, Boca has not hedged its interest rate risk. Assume that a steeply upward-sloping yield curve currently exists.
a. Boca asks you to assess its exposure to interest rate risk. Describe how Boca will be affected by rising interest rates and by a decline in interest rates.
b. Given the information about the yield curve, would you advise Boca to hedge its exposure to interest rate risk? Explain.
c. Explain why your advice to Boca may possibly backfire.

Answer 1

a. If a bank has long term assets such as fixed rate mortgages financed by short term liabilities, there is a mismatch in the duration of assets and this is known as asset liability mismatch. If short term interest rates rise, the short term liabilities get repriced while the yield on the long term asset does not change. So while the income from long term asset does not change the price of the short term assets have changed. This is also known as a maturity mismatch. So in the above case, the firm is exposed to ALM and interest rate risk. If there is a decline in short term interest rates, the firm would have to pay less for the short term liabilities but at the same time prepayment will increase on the long term assets.

b. The long term interest rates are higher than the short term interest rates which is positive for the firm. If the firm is anticipating a decline in interest rates, the firm can hedge its exposure using interest rate futures, options and swaps.

c. As the long term interest rates are higher, the firm's exposure may not be huge and hedging for interest rates unless there is a eminent decline, may cause additional expenses for the firm.