Question

Assume you are the assistant manager of a depository financial institution that holds marketable assets (loans and securities) and liabilities (deposits of various maturities). If you anticipate that interest rates will rise rapidly, over the next six months, describe and justify the portfolio adjustments you would recommend to your manager

Answer 1

Portfolio Management is defined as the art and science of making decisions about the investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance.

When interest rates change, many banks find themselves in a vulnerable condition, especially if the rates go up too much. One reason for that is the fact that what keeps a bank in business is primarily the difference between its interest earnings (on loans or bonds and securities) and its interest expenses (on deposits). If a bank has already invested a big part of its portfolio in long-term low-interest loans, the increasing interest rates under the competitive conditions, would force the bank to offer higher interest rates on deposits. That would be a recipe for bank’s diminishing profits or increasing losses, especially if the interest-rate upward movement continues for some rather long time.

Financial institutions have long used models as a means of reducing their exposure to risk. Whether the size of the financial institution assets is small, mid-sized, or large, the ability to minimize interest rate risk through portfolio management and the use of derivatives has become very demanding.

Through a better portfolio option the financial institutions can increase their revenue. Proper allocation to loans and securities were needed.