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1. A bank has an average asset duration of 4 years and an average liability duration...

1. A bank has an average asset duration of 4 years and an average liability duration of 1.5 years. This bank has total assets of $500 million and total liabilities of $450 million. Currently, market interest rates are 10 percent. If interest rates rise by 1 percent (to 11 percent), what is this bank's change in net worth?

a. net worth will decrease by $12.05 million

b. net worth will decrease by $15.45 million

c. net worth will increase by $12.05 million

d. either the net worth will not change at all, or none of these options are correct

e. net worth will increase by $15.45 million

2. The principal goal of an interest-rate hedging (risk management) strategy is to hold fixed a bank's:

a. net interest margin

b. noninterest spread

c. value of loans and securities

d. none of the options are correct

e. net income before taxes

Expert Solution

Question 1 :

As the interest rates have risen, the value of both asset and liabilities will decrease

Decrease in value of assets = Asset value * Duration * (i / (1 + i)

Decrease in value of liabilities = Liabilities value * Duration * (i / (1 + i),

where "i" is the interest rate

Therefore, decrease in value of assets = $500 million * 4 * (0.01 / (1 + 0.10), which is $18,181,818

decrease in value of liabilities = $450 million * 1.50 * (0.01 / (1 + 0.10), which is $6,136,364

Therefore, total decrease in net worth = decrease in value of assets minus decrease in value of liabilities

decrease in net worth = $18,181,818 - $6,136,364, which is $12,045,055. This is rounded off to $12.05 million

Therefore the correct answer is (a)

Question 2 :

The goal of interest rate hedging as a risk management strategy is to hold fixed the value of the bank's assets and liabilities.

The result is to hold fixed the value of the bank's securities and loans,

net income affects profitability and is not relevant in the asset-liability framework.

Net interest margin affects profitability and is not relevant in the asset-liability framework.

noninterest spread is again not relevant in this case

jeff jeffy answered 2 years ago

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