What type of interest rate risk will be occurred when Financial Institution holds liabilities with maturity...

What type of interest rate risk will be occurred when Financial Institution holds liabilities with maturity that are greater than the maturities of its assets? Explain what will be the impact on earnings when there are changes in the rate of interest. Justify your answer with support.

Expert Solution

Since the duration of assets is less than the duration of liabilities, there will be a reinvestment risk for the financial institution. Their assets will mature but the liabilities wouldn't and hence they would have to invest their assets again which can be at a rate quite different from what they had used earlier.

When the interest rate increases it would benefit them as now they will be able to invest at a higher rate and get a higher income but when the rate decreases, they would be able to invest at a lower rate and hence would lose out on interest income. For e.g. suppose if the bank has assets and liabilities of 100 each but the assets mature in 7 years, while the liabilities mature in 10 years. So, here what will happen is that after 7 years, they would have to search for new investments and if the interest rates would have decreased, they would be able to invest only at the reduced rates.

jeff jeffy answered 1 year ago

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