A $995 Million Bank Has a Negative Repricing Gap Equal

question 28

Essay

A $995 million bank has a negative repricing gap equal to 6 percent of assets. The bank is currently paying 4.5 percent on its rate-sensitive liabilities. These rates will vary as interest rates move. The managers wish to reduce the effective repricing gap to zero with an interest rate cap or floor. A one-year cap is available with a 5 percent cap rate and a one-year floor is available at a floor rate of 4 percent.
(a)Suggest a position using either the cap or the floor (but not both)that will limit the bank's interest rate risk. Explain.
(b)Suppose that interest rates are volatile this year and the cap costs $275,000 and the floor costs $195,000. Suggest a collar that helps limit the bank's cost of hedging. How does the collar affect the bank's risk?

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Definitions:

Company

An organization or entity engaged in commercial, industrial, or professional activities, either for-profit or nonprofit.

Fisher Effect

An economic theory proposing that the real interest rate is independent of monetary measures, particularly the nominal interest rate and expected inflation.

Nominal

Refers to the face value of a financial instrument or the expressed value of a currency without adjusting for inflation.

Real Rates

Interest rates or rates of return that have been adjusted for inflation, reflecting the true cost of borrowing or the true yield on an investment.