EOC solutions Chapter 22

EOC solutions Chapter 22 - Answers to Chapter 22 Questions...

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Answers to Chapter 22 Questions: 1. Through its daily open market operations, such as buying and selling Treasury bonds and Treasury bills, the Fed seeks to influence the money supply, inflation, and the level of interest rates. When the Fed finds it necessary to slow down the economy, it tightens monetary policy by raising interest rates. The normal result is a decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if business and household spending decline to the extent that the Fed finds it necessary to stimulate the economy it allows interest rates to fall (an expansionary monetary policy). The drop in rates promotes borrowing and spending. 2. The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a roll over of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a new loan at current market rates) or because the asset or liability is a variable rate instrument (e.g., a variable rate mortgage whose interest rate is reset every quarter based on movements in a prime rate). Rate sensitivity represents the time interval where repricing can occur. The model focuses on the potential changes in the net interest income variable. In effect, if interest rates change, interest income and interest expense will change as the various assets and liabilities are repriced, that is, receive new interest rates. 3. The maturity bucket is the time window over which the dollar amounts of assets and liabilities are measured. The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The longer the repricing period, the more securities either mature or will be repriced, and, therefore, the more the interest rate risk exposure. An excessively short repricing period omits consideration of the interest rate risk exposure of assets and liabilities are that repriced in the period immediately following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet. An excessively long repricing period includes many securities that are repriced at different times within the repricing period, thereby overstating the rate sensitivity of the balance sheet. 4. The CGAP effect describes the relations between changes in interest rates and changes in net interest income. According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in interest rates.
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