Question

State whether you agree or disagree with the following statement. Explain why.

"A bank with a negative duration gap can hedge its interest rate risk by buying (as opposed to selling) Treasury bond futures."
(Note: You are only considering whether the bank should buy or sell T-bond futures; you are not considering other ways to hedge interest rate risk.)

Answer 1

I will agree with the statement.

• With a negative duration gap, a bank will see a decline in the market value of equity if interest rates fall.
• This is because the market value of assets would increase less than the market value of liabilities.
• Taking a long position in financial bond futures can help bridge this exposure.
• With such a position, decline in interest rates would produce losses in the futures market position that could be used to offset the gains in the cash market position. Note that decline in interest rate will lead to increase in the bond prices.