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) The mortgages are fixed-rate mortgages and hence is any immune to changes in any changes in market interest rates. However, all these mortgages are financed with funds from short-term deposits that are prone to market risks as the interest rate would keep getting rolled over after the short duration and the new rates again would be subjected to the new market interest rates. In this case, if the interest rates rise, Boca will be adversely affected as its outflows are fixed at higher rates and inflows will be reduced.

b) A yield curve is a graphical representation of market interest rates for different maturity. An upward sloping yield curve indicates that interest rates in the long-term will be higher than in the short term. In short, this means that long-term yields are rising at a faster rate than short-term yields. Looking at the yield curve, it is advisable for Boca to hold its exposure to interest rate risk.

c) The decision may possibly backfire, as there is always a risk associated with completely relying on the yield curve. Any black swan event can change the market interest rates and the yield curves. Hence, any such changes (rising short-term interest rates) can lead to Boca's value being adversely affected.