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:

George H.W. Bush

The 41st President of the United States, serving from 1989 to 1993, known for his leadership during the end of the Cold War and the Gulf War.

Berlin Wall

A fortified barrier that divided Berlin from 1961 to 1989, built by the German Democratic Republic (East Germany) to prevent East Germans from fleeing to West Berlin and West Germany.

East Germany

Officially the German Democratic Republic (GDR), a state that existed from 1949 to 1990 in the eastern part of Germany, established after World War II and during the Cold War.

CIA

The Central Intelligence Agency, a civilian foreign intelligence service of the federal government of the United States, tasked with gathering, processing, and analyzing national security information.