Assume that a bank expects to attract most of its funds through short-term CDs and would...
- Assume that a bank expects to attract most of its funds through short-term CDs and would prefer to use most of its funds to provide long-term loans. How could it follow this strategy and still reduce interest rate risk?
Homework Answers
Managing interest rate risk
The bank is going to attract funds using a CD (Certificate of Deposit) which is a saving certificate with a fixed maturity rate.
The bank is going to use its fund to provide long term loans.
A fixed-rate loan may be perceived as rate insensitive. Yet, if it is prepaid, the funds are loaned out to someone else at the prevailing rate. Therefore, this type of loan can be sensitive to interest rates. A bank could follow the strategy that the bank expects to attract most of its funds through short-term CDs and would prefer to use most of its funds to provide long-term loans and still reduce the interest rate risk by using the floating-rate loans even with long-term maturities.
The floating rate is also known as variable or adjustable rate hence this strategy can be used to manage the interest rate risk.
Regards,
Mike
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