Question

Blue Sunday Bank has a portfolio of loans and securities, as well as deposits and money market borrowings, which are expected to produce the following cash inflows and outflows for the bank in the coming 5 years. Explain the danger of the bank’s position. What kind of hedging should the bank use to reduce its risk and what's the expected effect?

Duration of Total Cash Inflows
Expected Cash Flow	Cash Flow Timeline	Current Year	Present Value (4.5%)	Present Value	Weight	Duration
1900000	1 Year	1	0.956937799	1818181.818	0.63258399	0.63258399
750000	2 Years	2	0.915729951	686797.4634	0.238951394	0.477902788
350000	3 Years	3	0.876296604	306703.8114	0.106708756	0.320126269
65000	4 Years	4	0.838561344	54506.48733	0.018963962	0.075855849
10000	5 Years	5	0.802451047	8024.510465	0.002791897	0.013959486
				2874214.091		1.520428382
Duration is 1.520428 Years
Duration of Total Cash Outflows
Expected Cash Flow	Cash Flow Timeline	Current Year	Present Value (4.5%)	Present Value	Weight	Duration
-1400000	1 Year	1	0.956937799	-1339712.919	0.531606644	0.531606644
-830000	2 Years	2	0.915729951	-760055.8595	0.30159502	0.60319004
-400000	3 Years	3	0.876296604	-350518.6416	0.139088036	0.417264108
-45000	4 Years	4	0.838561344	-37735.26046	0.014973592	0.05989437
-40000	5 Years	5	0.802451047	-32098.04186	0.012736708	0.06368354
				-2520120.722		1.675638701
Duration is 1.675639 Years

Answer 1

Answer ) In the current situation and financial cash flow portfolio condition of Blue Sunday Bank, the net present cash inflow is higher than cash outflow , but varies in duration .

Concept od Duration of cash flow , measures the sensitivity of cash flow on change ininterest. The higher duration , the greater its percentage price volatility.The cash outflow protfolio has high value in duration (1.675639 yrs) in comparision to cash iflow portfolio (1.520428 Years). This clearly alarm a danger situation for bank , the cash outflow is more sensitivity to change in interest rate than cash inflow.

The cash flow portfolio duration risk can be hedged by use of fixed rate on interest rate swaps or by taking short positions in bond futures.As in the current situation of bank the outflow are more price sensitive than inflow ,always create a position in future bond market to reduce the differential risk.