Question

1. Define adverse selection.

2. Assets = $100 million, Liabilities = $70 million, Average asset duration = 3 years, Average liability duration = 2 years. Suppose the interest rate decreases by 4%. What will be change in net worth (in dollar)?

3.Explain how price level affects exchange rates in the long run?

4.Do the duration analysis based on the following information.

5.If a bank’s liabilities are $90 million and assets are $70 million, calculate the change in bank profit in case of 4% decrease in interest rates? Assume both liabilities and assets are rate-sensitive.

6.What are the functions of the IMF? What are the criticisms of the IMF?

7.Explain dollarization.

8.If expected future exchange rate of Saudi Riyal (SAR) increases, what will happen to the exchange rate of SAR now? Explain with a GRAPH. What will be change in net worth (in dollar)?

Answer 1

1. Adverse Selection is a market situation where there is asymmetric or unequal information between buyers and sellers. It refers to a scenario where either the buyer or the seller possess some undisclosed information about the quality, feature or trait of a product which the other party is not aware about. This unequal information generally disrupts and distorts the market

2. By formulae, Durationgap=Duration of assets-(Liabilities/Assets*Duration of Liabilities)

As per the given problem Durationgap=3-(70/100*2) or. 1.6

Now, change in % change in networth= -Durationgap*[change in interest rate/(1+interest rate)]

Here, % change in networth=-1.6*[-0.04/(1+0.1)] i has been assumed to be 10%

There, %Change in NW=0.058 or, 5.8%.  

The absolute change in Net Worth will be=$100 million*5.8% or, $5.8 million.

Therefore, we can say that the net worth will increase by $5.8 million.