1. Assume the following exchange rate quotes on British pounds: Bid Ask Orleans

Question

1.Assume the following exchange rate quotes on British pounds:

                            Bid           Ask

Orleans Bank      $1.46        $1.47

Kansas Bank    1.48          1.49

Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the exchange rates. (10)

2.What is Duration Gap? (5)

3.What do you mean by Maturity Matching and how does it help in reducing Interest Rate

Risk? (10)

4.Explain how Risk Premium Changes affects the required rate of Return for a Commercial

Bank? (10)

5.What is a Bank leverage? (5)

6. Kansas City Bank had interest revenues of $80 million last year and interest expenses of $35. About $400 million of its $1 billion in assets are rate sensitive, and $700 million of its liabilities are rate sensitive. (20 points)

a) What is the Bank’s net interest margin?
(Usetheformula: NetInterestMargin=(Interestrevenue-InterestExpenses)/Assets

b) What is the Gap of the Bank?
Use : Gap = rate sensitive assets – Rate sensitive liabilities

c) What is the Gap ratio?
Use : Gap Ratio = rate sensitive assets / Rate sensitive liabilities

Explanation / Answer

1. yes, there is a chance for arbitration in the given example; i.e. an investor can buy pound at $1.46 and he can sell it at $1.49 per pound. he can buy it in Orleans and sell it in Kansas bank simultaneous. arbitrageurs facilitates to equlize the market price of an asset/commodity or instrument in a market.

2. the gap between maturity periods of a contract is called duration gap. usually the gap between contracts will be different from one another.

3. matching the payment or receipt of a loan or interest to different loans at different maturity periods is called maturity matching. the payer or receiver will be match their payment periods with one another and the obligtations will be change to one another.

4. if the potential risk is high, the banker will expects higher return on their lending and vice versa. suppose as a banker if you lend funds to a local business people with no surity, usually you may charge higher interest rate than the one who provides proper security to the loan.

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