Question

1.a)What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk?

b) Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return and the second bond is a zero-coupon bond that pays only a lump-sum payment after 10 years with no interest over its life. Which bond would have more interest rate risk? That is, which bond's price would change by a larger amount for a given change in interest rates? Explain your answer.

2. If a bank manager is certain that interest rates were going to increase within the next six months, how should the bank manager adjust the bank's maturity gap to take advantage of this anticipated increase? What if the manager believes rates will fall? Would your suggested adjustments be difficult or easy to achieve?

Answer 1

Ans: a, Asset transformation is the process of creating a new asset from liabilities (deposits, long term debt) and issuing them to public. Eg. Banks take deposits from customers and issue loans to customer who need loans by charging interest rate, thus converting liabilities (deposits) into loans(assets).

For financial institutions it is converting primary assets into different assets with different risks and maturities.

Interest rate risk occurs because the price and reinvestment income of long term assets react differently to changes in market interest rate fluctuations as compared to denominated assets made from those long term assets through asset transformation.

Interest rate risk is the risk that arise to the value(usually price) of an asset from fluctuations in the market interest rate.

b, Duration of zero coupon bonds is higher as compared to duration of coupon paying bond. Since increase in interest rate and is inversely proportional to price of a bond as,

So as zero coupon bond has higher duration so it has high interest rate risk as compared to coupon paying bond.

2. so if duratiin gap is positive and interest rate rise, it will be loss for bank.

Inorder to avoid loss, bank needs to reduce duration gap or make it negative.

Since, so bank can increase liabilities by taking more and more deposits to make duration gap negative.

Similarly if interest rate falls, banks should issue more loans to make duration gap positive to make profit.

This approach will be easy to achieve as these are the primary functions of bank.