Question

1.		During the first year, Trust Bank has $150 million in one-year loans earning a fixed interest rate equal to 9%. During the first year Trust Bank has $150 million in deposits, and the maturity of these deposits is 3 years. The bank has to pay 6% on its deposits. Is Trust Bank making a profit on these operations? Why or why not? b. During the second year, people become pessimistic and their appetite for borrowing is reduced. Trust Bank is forced to reduce the interest on its loans to 5.5%. Is Trust Bank suffering from refinancing risk, credit risk, or reinvestment risk during the second year? Explain your answer.

Answer 1

1.a.

Bank is earning income at an interest rate of 9%; Bank is spending the money at a cost of 6%.

Hence interest rate spread=3% ; ie Bank will earn at 3% in the first year from 150 Million dollars available.

ie: Profit=150*3% =4.5 Mllion dollar profit

1.b.

The 9% loan through which the bank is earning income is for a period of 1 year. As given in the question, people stopped borrowing money from the Bank in 2nd year. Due to this the source of income of the bank has vanished. Hence Bank is only spending money to the depositors at rate of 5.5% interest(forced to change from 6%).

This scenario can lead the Bank to suffer from reinvestment risk as the bank is unable to invest the depositors money into giving loans or other business which can severely affect its functioning and profitability.

Credit risk and refinancing risk will not be applicable for the bank in the 2nd year. However after the 3rd year this issue can happen.