Question

A bank has a negative duration gap and wishes to hedge to use an interest rate swap to hedge its interest rate risk. The bank should

Pay a variable rate of interest and receive a fixed rate of interest

Pay a fixed rate of interest and receive a variable rate of interest

Pay a fixed rate of interest and receive a fixed rate of interest

Pay a variable rate of interest and receive a variable rate of interest

Answer 1

A negative duration gap means that liabilities are more price sensitive than assets. When interest rates decline, it is good for a bank as the liabilities will be re-priced at a lower interest rate hence adding to the income and when interest rates increase, the liabilities will be re-priced at higher rates thus resulting in higher outflows.

Hence in case of a negative gap, the bank will have to hedge the interest rate risk and safegaurd against the upside increase in interest rate. So inorder to curb the upside risk of an increased interest rate, the bank should pay a fixed rate of interest and receive variable rate of interest. This way a bank is secured when the interest rates rise.

Hence Option B i.e. Pay a fixed rate of interest and receive a variable rate of interest is correct.