a Is the bank longfunded or shortfunded What types of intere

a. Is the bank long-funded or short-funded? What types of interest rate risk is the bank exposed to? Explain. (2 DO?nts)

Solution

A. Whether the bank is Short funded or Long funded, it depends on its Asset and liability size and its maturity profile. When liability has lower net maturity profile as compared to asset of the bank it is called short funded. And if Assets have lower net maturity profile as compared to liability it is called long funded. let us understand both in examples.

1. Short Funded:

Asset Size: 100 million dollar : Maturity 2 years

Liability : 100 million dollar : Maturity 1 year

because bank will require funding for 2 nd years. resulting in funding risk.

2. Long Funded:

Asset : 100 million dollar : maturity 1 year

Liability: 100 million dollar: maturity 2 years

Because bank needs to find out re invesment strategy for 2nd year. resulting in reinvestment risk.

b.  Interest rate risk is the risk that a bank’s net income will be negatively affected by a change in the market interest rate.

In general interest rate risk can be classified by reinvesment or refunding gaps in the balancesheet of the bank. however as basel classified different types of interest rate risk that bank is exposed to are as follows:

1. Gap Risk: This is the risk arising out od timing of the change in interest rate for different instruments. This basically refers to gaps in term structure of instruments in books of bank.

2. Non-parallel gap risk: This refers to change in relative interest rate in different instruments with different maturities. This creates a problem in hedging the gaps in books.

3. Basis: This refers to gaps produced in interest rate on account of different refrence points of yield curve in pricing instruments.

4. Optionality risk: This refers to non-linear price movements in instruments to interestrate risk.