Question

Q. Using appropriate models, discuss the three factors that affect changes in the net worth of a financial institution when interest rates change. Assume that only duration is used for portfolio immunization purposes..

Q. Discuss whether interest rate risk is a big concern for investors given today’s economic environment.

Answer 1

ANSWER :

Q 1.INTEREST RATE CHANGE AND ITS EFFECTS ON NET WORTH OF A FINANCIAL INSTITUTION.

In the case of financial institutions they have Interest expenses as well as Interest Incomes . Like :

1. Interest to be paid on loans , deposits bonds etc etc taken . Here the increase in interest rate will reduce their profit or increase their losses. This will reduce its net worth . Similarly a reduction in the market lending rates will reduce the financial institutions interest out flow , resulting in increase in the profits ar reduction in their losses. This will increase their net worth.

2. An increase in interest rates will increase thier income on investments, loans advanced etc . This will have an effect of increasing their profits or reducing their losses resulting an increase in net worth. Similarly a reduction in interest rates will reduce their income receipts resulting in reducing profits or increase in losses. This will result in decreasing the Net worth.

Portfolio immunisation is an investment strategy used to minimise the interest rate risk of bond investments by adjusting the portfolioduration to match the investor's investment time horizon.

Q. 2 INTERST RATE RISK AND INVESTMENTS

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market . The sensitivity depends on two things, the bond's time of maturity and the coupen rate of the bond.

Similarly in all invement instruments this risk factor is their. In a sluggish economic condition like this where the econmy is not showing any sign of positivity the investors will be put in deep uncertanity.