Time left 0:13:34Question 19Not yet answeredMarked out of 20.00Flag questionTipsQuestion textBank A has 30-year mortgages with fixed-rate interest rates as assets. It finances these assets with short-term deposits (maturities shorter than a year).(a) Does Bank A have a positive or negative duration gap? Explain Bank A’s interest rate risk exposure. (5 marks)(b) Can you guess whether Bank A’s managers expect a decrease or an increase in interest rates? Explain your answer. (5 marks)(c) Explain how Bank A can use futures contracts to hedge its interest rate risk. (5 marks)(d) Explain how Bank A can use a swap contract to hedge its interest rate risk. (5 marks)Answer text Question 19Rich text editor
Question
Time left 0:13:34Question 19Not yet answeredMarked out of 20.00Flag questionTipsQuestion textBank A has 30-year mortgages with fixed-rate interest rates as assets. It finances these assets with short-term deposits (maturities shorter than a year).(a) Does Bank A have a positive or negative duration gap? Explain Bank A’s interest rate risk exposure. (5 marks)(b) Can you guess whether Bank A’s managers expect a decrease or an increase in interest rates? Explain your answer. (5 marks)(c) Explain how Bank A can use futures contracts to hedge its interest rate risk. (5 marks)(d) Explain how Bank A can use a swap contract to hedge its interest rate risk. (5 marks)Answer text Question 19Rich text editor
Solution
(a) Bank A has a negative duration gap. This is because the duration of its assets (30-year mortgages) is longer than the duration of its liabilities (short-term deposits). This means that Bank A is exposed to interest rate risk. If interest rates rise, the value of its assets (the fixed-rate mortgages) will fall more than the value of its liabilities (the short-term deposits), leading to a decrease in the bank's net worth.
(b) It's hard to say definitively without more information, but given that Bank A has a negative duration gap, it's possible that the bank's managers expect a decrease in interest rates. This is because a decrease in interest rates would increase the value of the bank's long-term assets more than its short-term liabilities, leading to an increase in the bank's net worth.
(c) Bank A can use futures contracts to hedge its interest rate risk by selling interest rate futures. This would allow the bank to lock in a future interest rate for its short-term deposits. If interest rates rise in the future, the bank would make a gain on the futures contract that would offset the loss on its assets.
(d) Bank A can use a swap contract to hedge its interest rate risk by entering into an interest rate swap where it pays a fixed rate and receives a floating rate. This would effectively convert the bank's fixed-rate assets into floating-rate assets, reducing its exposure to interest rate risk. If interest rates rise, the bank would receive higher payments on the swap contract, offsetting the loss on its assets.
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