Question

              1.   a. Why rising interest rates would decrease the Net

            worth of a bank operating under normal conditions

            (going concern). How would it affect the Net worth of a

            bank under liquidation? (10%)

       b. Can a portfolio manager guarantee the capital of his client

            investing in a stock market over say a five year period and

            generate some return, irrespective of the performance of

            the stock market over this period ? Explain how? (10%)

       c. How can a bank manage its systematic risk , if at all? (5)

Answer 1

Q-1)

a) Under rising interest rate banks net worth can decrease because of mainly two reasons. The first is when the interest rates are rising the bank will have to pay more interest to depositors to attract deposit and it can increase the liability for the bank, the other is when the interest rates increase the loans which it has provided, the probability of default also increases so banks loans to others are its asset and its value would start to decline, when the asset value decreases, it net worth will also decrease. The net worth under liquidation would be seriously negatively affected because its asset would not be very liquid and it will be sold at far less than its fair value so under liquidation, the net worth would decline.

b) A portfolio manager can never guarantee a certain level of return on his capital or his capital at all, what portfolio managers do is that they attach probability level to each investment in stock market and provide explanation to client that your investment is safe to at certain extent. Let’s take the example of blue-chip stock, if you invest in them then your probability of loosing capital is low because besides price appreciation, they also provide dividend.

c) The focus of bank is not on managing systematic risk but more on managing interest rate risk. The bank has asset liability management committee which provide guidelines on how the bank is going to manage its interest rate risk. Normally it done by matching the duration of its liabilities with the assets.