A bank with a two-year horizon has issued a one-year certificate of deposit for
ID: 2647124 • Letter: A
Question
A bank with a two-year horizon has issued a one-year certificate of deposit for $50 million at an interest rate of 2 percent. With the proceeds, the bank has purchased a two-year Treasury note that pays 4 percent interest. What risk does the bank face in entering into these transactions?
The bank faces the risk that the short-term interest rate will (Rise/Fall) before the second year, (Decreasing/Increasing) the amount of interest the bank has to pay on the CD, but leaving the interest income that the bank receives from the Treasury note unchanged.
With an interest rate of 2 percent for the CD and 4 percent for the Treasury note, the bank
Explanation / Answer
Answer:
1. The bank faces the risk that the short-term interest rate will (Rise) before the second year, (Increasing) the amount of interest the bank has to pay on the CD, but leaving the interest income that the bank receives from the Treasury note unchanged.
2.
Annual income of bank = Annual interest on Treasury note =$50000000 * 4% = $2000000
Annual expense of bank = Annual interest on CD=$50000000 * 2% = $1000000
Annual Profit for Bank = $2000000 - $1000000 = $1000000
3. If all interest rate rises by 1% then:
Annual income of bank = Annual interest on Treasury note =$50000000 * 5% = $2500000
Annual expense of bank = Annual interest on CD=$50000000 * 3% = $1500000
Annual Profit for Bank = $2500000 - $1500000 = $1000000
Hence, there shall be no effect on Profits.
4. If all interest rate rises by 1% in year 2 then:
Income of bank = interest on Treasury note =$50000000 * 4% = $2000000
Expense of bank = interest on CD=$50000000 * 3% = $1500000
Annual Profit for Bank = $2000000 - $1500000 = $500000
Hence, the profits shall fall by 1000000-500000 =$500000
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