S&K Saving Bank is a medium size bank and operating locally. It provides different financial services to individuals and businesses. In January 2011, S&K Saving Bank has issued saving certificate (certificate of deposits) for Rs. 1,000 with one year maturity at 4% interest rate.
In next year bank will reissue the certificate of deposits; on reissuance interest rate on these may vary due to change in inflation rate and monitory policy.
With the borrowed money the bank has purchased treasury bonds for Rs 1000 at 8% fixed interest having two year maturity. Previous trend shows that interest rate may rise by 1-2 percent.
Required: Keeping in view all these information, what type of risk the bank will face while entering into these transactions? Also mention the valid reason for choosing this type of risk.
Solution:
The bank faces interest rate risk. In the case of borrowing from the depositor, it faces the risk that interest rates will fall below 4% (where it could have borrowed below 4%). In the case of the purchase of the treasuries, it faces the risk interest rates will rise - decreasing the value of its bond holdings. The risks are valid because the bank has "hedged" it borrowing (at 4%) with its investing (at 8%) for at least the first year. In the second year, if interest rates rise, it will have to "borrow" at a higher rate at the same time that its bond is worth less (because interest rates have risen). With a 1-2% rate increase, the bank will still have a "spread" between the rate at which it borrows and the rate of return on the bond.
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