Chapter%208%20Problems_Solutions - Chapter 08 - Interest...

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Unformatted text preview: Chapter 08 - Interest Rate Risk I Chapter Eight Interest Rate Risk I Solutions for End-of-Chapter Questions and Problems 1. How do monetary policy actions made by the Federal Reserve impact interest rates? 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. How has the increased level of financial market integration affected interest rates? Increased financial market integration, or globalization, increases the speed with which interest rate changes and volatility are transmitted among countries. The result of this quickening of global economic adjustment is to increase the difficulty and uncertainty faced by the Federal Reserve as it attempts to manage economic activity within the U.S. Further, because FIs have become increasingly more global in their activities, any change in interest rate levels or volatility caused by Federal Reserve actions more quickly creates additional interest rate risk issues for these companies. 3. What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity? On what financial performance variable does the repricing model focus? Explain. 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. 4. What is a maturity bucket in the repricing model? Why is the length of time selected for repricing assets and liabilities important when using the repricing model?...
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This note was uploaded on 01/26/2012 for the course FIN 4620 taught by Professor Patriciarobertson during the Spring '12 term at Kennesaw.

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Chapter%208%20Problems_Solutions - Chapter 08 - Interest...

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