HW #3-Types of Risks Facing Financial Institutions This homework assignment is w
ID: 2826501 • Letter: H
Question
HW #3-Types of Risks Facing Financial Institutions This homework assignment is worth up to 20 points toward your final grade. 1. Suppose a bank has the following assets and liabilities on its balance sheet: Loans CDs $100 million $100million 3.75% 3.15% 5 years 3 years All rates are locked in for the period of time specified. a. Is the bank long-funded or short-funded? What types of interest rate risk is the bank exposed to? Explain. (2 points) b. What is the bank's spread? (2 points) C. If interest rates are expected to rise by 0.5% in Year 3, what will happen to the bank's spread? (3 points) d. If interest rates are expected to decline by 0.25% in Year 3, what will happen to the bank's spread? (3 points)Explanation / Answer
a.
Bank is short funded because the CDs or deposits (Liabilities) are for 3 years Vs Loans (Assets) are for 5 years.
Interest rate risk for bank is that bank is exposed to Gap exposure, the maturity of CD is early than the loans hence spike in interest rate would reprice the CD at higher rate after 3 years and make overall net margin or net interest income lower than the expected.
b.
Bank’s spread = Interest rate on loan - Interest rate on CD
= 3.75%-3.15%
= 0.60%
c.
If Interest is expected to rise by 0.50% in Year 3, then, the spread will narrow down because, the CD rates will reset at end of their maturity that is in 3 years from now and bank has to borrow at higher rate of 3.65%. There will no change in Loan rate since they are locked for 5 years.
The revised spread would be:
Bank’s spread = Interest rate on loan - Interest rate on CD
= 3.75%-3.65%
= 0.10%
d.
If Interest is expected to decline by 0.25% in Year 3, then, the spread will expand because, the CD rates will reset at end of their maturity that is in 3 years from now and bank can borrow at lower rate of 2.90%. There will no change in Loan rate since they are locked for 5 years.
The revised spread would be:
Bank’s spread = Interest rate on loan - Interest rate on CD
= 3.75%-2.90%
= 0.85%
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