Question

Suppose you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank's interest-rate risk?

Answer 1

Solution:

We need to find the duration gap first to understand the impact of change of interest

Duration gap = Duration of asset - duration of Liability * paying Liability / Earning asset

Duration gap = 4 - 6 * 90/100 = 4 - 5.4 = -1.4

Here duration gap is negative and it means that liability will lose mare value than asset and thus it will increase the firm's equity.

So we can say that net worth of the company will increase.

In order to reduce the interest rate risk of the bank we need to have assets that have higher durations .