Question

Consider the balance sheet of the Bank of America

                    ASSETS                                               LIABILITIES

Rate-sensitive assets             $50 million       Rate-sensitive liabilities     $70 million

Fixed-rate assets                    $50                  Fixed-rate liabilities            $30 million

Suppose that interest rates rise by 1 percentage points on average, from 4% to 5%

a. How will the increase in interest rates affect income on the assets?

b. How much will the increase in interest rates affect payments on the liabilities?

c. What has happened to the bank’s profits as a result of this interest rate increase?

d. Does this example prove that the bank suffers from interest-rate risk? Why or why not?

Answer 1

Solution to part (a):

Increase in interest rates will increase the interest income by $50 million * 1% = $500,000.

Solution to part (b):

Increase in interest rates will increase the interest expense by $70 million * 1% = $700,000.

Solution to part (c):

As a result of increase in interest rate profits will decrease by $200,000 ($700,000 - $500,000)

Solution to part (d):

This example prove that the bank suffers from interest-rate risk. Due to change in interest-rate there was a decrease in profits of the Bank.

If interest rates increase, Some Bank’s gross profits, the difference between what it pays for its liabilities and earns on its assets, will decline (assuming the spread stays the same) because the value of its rate-sensitive liabilities (short-term and variable-rate time deposits) exceeds that of its rate-sensitive assets (short-term and variable- rate loans and securities).