# Economics assignment

1. The bank you own has the following balance sheet: (2 points)

Assets Liabilities

Reserves \$ 75 million Deposits \$ 500 million

Loans \$ 525 million Bank capital \$100 million

If the bank suffers a deposit outflow of \$50 million with a required reserve ratio on deposits of 10 percent, what action must you take to keep your bank from failing? Show underlying work

2. Suppose you are the manager of the bank that has \$15 million of fixed-rate assets, \$30 million of interest rate– sensitive assets, \$20 million of interest rate insensitive liabilities and \$20 million of interest rate sensitive liabilities. (4 points )

a. Is the bank rate sensitivity gap positive or negative? Explain why

b. What is the size of this bank rate gap?

c. If the short-term interest rates rise by 5 percent by what amount will the bank profit increase or decrease?

d. What action should the bank take to reduce the interest-rate risk? Explain

e. If the short-term interest rates fall by 5 percent, by what amount will the bank profit increase or decrease?

f. What action should the bank take to reduce the interest-rate risk? Explain

g. Explain how you can use the interest rate swaps to reduce the bank interest rate risk.

3. Suppose you are the manager of the bank that has \$15 million of fixed-rate assets, \$30 million of interest rate– sensitive assets, \$20 million of interest rate insensitive liabilities and \$20 million of interest rate sensitive liabilities. (2 points)

a. Is the average duration of the bankâ€™s assets greater than the average duration of its liabilities? Why?

Further assume that an average duration of the bankâ€™s assets is of 3 years while an average duration of its liabilities is of five years.

a. Conduct a duration analysis for the bank, and show numerically what will happen to the bank capital if short-term interest rates rise by 2 percentage points.

b. What action should the bank take to reduce interest rate risk? Explain

4. Briefly explain whether you agree with the following statements:

a. â€œ A bank that expects interest rates to increase in the future will want to hold more of rate -sensitive assets and fewer rate- sensitive liabilitiesâ€

b. â€œA bank that expects interest rates to decrease in the future will want the duration of its assets to be greater than the duration of its liabilitiesâ€

c. â€œIf the bank manager expects interest rates to fall in the future, the manager should increase the duration of the bankâ€™s liabilitiesâ€

Extra Points (4 points)

1. â€œBecause diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loansâ€. Is this statement true false or uncertain? Explain your answer

2. Before 1933, there was no federal deposit insurance. Was the liquidity risk faced by banks during those years likely to have been larger or smaller than is today? Briefly explain

3. Suppose that you are considering investing in a bank that is earning a higher ROE than most of the banks. You learn that the bank has \$300 million in assets in bank capital and \$5 billion in assets. Would you become an investor in this bank? Briefly explain

4. â€œWhen bank lends long and borrows short, an increase in the interest rates will drive down the bankâ€™s profitsâ€. True or false? Explain

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