FM201 - Financial Institutions & Markets

Tutorial 9 Solutions

Chapter 14
1. Understanding the re-pricing of financial assets and liabilities is essential in interest rate risk measurement
and management. Explain and discuss the basic principle of ‘assets re-priced before liabilities’ (ARBL). Use
examples to support your answer.
 Interest rate risk is the sensitivity of assets, liabilities and cash flows to changes in interest rates.
 Understanding the repricing of assets and liabilities is essential in interest rate risk measurement and management.
 ARBL principle: if interest rates are forecast to rise, endeavour to reprice assets before liabilities; that is, try to
achieve a positive ARBL gap.
 A positive ARBL gap means that an organisation is able to benefit, at least in the short term, from an upward
movement in interest rates.
 For example, a bank provides its customers with loans that represent assets on the bank’s balance sheet. The loans
are funded from borrowings, being mainly liabilities on the balance sheet. If interest rates are forecast to rise in the
future the bank will be able to increase its net interest margin if it can raise the interest rates on its loan assets before
it has to increase the interest rates it pays on its deposit liabilities.
 If the same bank had a negative ARBL gap and forecast interest rates to rise it would seek to reduce or remove the
negative gap.
 In an environment where interest rates are expected to fall, an organisation will endeavour to reduce a positive
ARBL and try to achieve a negative ARBL gap.
 An organisation needs to measure and manage ARBL over a range of planning periods; difficult to change the
structure of a large balance sheet quickly.
2. Re-pricing gap analysis requires the identification of the interest rate sensitivity of assets and liabilities,
within different planning periods, into three specific groupings.
a. Define and discuss the three groupings.
 Repricing gap is defined as rate sensitive assets minus rate sensitive liabilities.
 In order to calculate the gap, assets and liabilities are grouped according to their interest rate characteristics in
that planning period.
 Assets and liabilities are grouped as the value of:
1. interest sensitive assets financed by interest sensitive liabilities
2. fixed rate assets financed by fixed rate liabilities and equity
3. rate sensitive assets financed by fixed rate liabilities (or vice-versa).

b. Explain why different planning periods are used and the impact of the different planning periods on the
grouping of assets and liabilities.
1. Interest sensitive assets financed by interest sensitive liabilities—if interest rates change the movement will
impact both sides of the balance sheet. Based on the assumption that interest rates will move at the same time and to
 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

the same extent for both assets and liabilities then there is no interest rate risk exposure. In reality this assumption is
weak and timing differences will often be evident.
2. Fixed rate assets financed by fixed rate liabilities and equity are not exposed to interest rate risk during a planning
period as the cost of funds and the return on funds is fixed, that is, repricing does not occur.
3. Rate sensitive assets financed by fixed rate liabilities (or vice-versa)—one side of the balance sheet will be
exposed to interest rate risk while the other is not. This represents the interest rate risk exposure under the repricing
gap model

3. A regional bank uses re-pricing gap analysis as its main interest rate risk measurement tool. Each month, the
bank generates a report that categorises assets and liabilities by the interest rate sensitivity over a one-month
(30-days) planning period. The latest report is shown below:

Average Average
Assets $ billions yield (%) Liabilities $ billions yield (%)

Fixed-rate personal 15 8.15 Demand deposits 18 0.25

loans > 30 days

Variable-rate 48 8.50 Term deposits > 30 36 4.50

personal loans > days
30 days

Fixed-rate 8 9.95 Term deposits < 30 10 3.85

commercial days
loans < 30 days

Variable-rate 26 9.70 Certificates of deposit 12 4.15

commercial > 30 days
loans < 30 days

Treasury bonds > 10 4.25 Long-term debt 31 6.25

30 days securities (fixed)

Total 107 107

a. Calculate the current re-pricing gap.

Rate sensitive assets: $ billions
– variable-rate personal loans >30 days 48
– fixed rate commercial loans < 30 days 8
– variable-rate commercial loans > 30 days 26
– total 82
Rate sensitive liabilities:
– demand deposits 18
 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

– term deposits < 30 days 10

– total 28

Repricing gap = rate sensitive assets minus rate sensitive liabilities

= $82 billion - $28 billion
= $54 billion

b. If interest rates are forecast to increase by 25 basis points at the start of the one-month (30-days) planning
period, what will be the annualised dollar impact on the profitability of the bank?

Show all calculations.

 Change in profitability = gap x change in rates x period
= $54 billion x 0.0025 x 30/365
= $11 095 890.41
 The bank had a positive gap and interest rates increased by 25 basis points, therefore profitability has increased
by $11 095 890.41

4. Listed below is a simplified balance sheet showing the dollar value and duration of assets and liabilities held.
For ease of calculation, we will assume an average interest rate of 6.00 per cent per annum; that is r = 0.06.

Assets $ millions Duration

Debentures 41 6.885
Euronotes 25 4.420
Government bonds 10 3.345
Total assets 76
Liabilities
Short-term commitments 25 1.485
Long-term debt issues 38 5.844
Total liabilities 63
Equity 13

a. Calculate the duration of the asset portfolio and the duration of the liability portfolio.
$ millions Duration Proportion of Relative
portfolio duration
Assets
Debentures 41 6.885 0.54 3.71
Euronotes 25 4.420 0.33 1.45
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Tutorial 9 Solutions

Government Bonds 10 3.345 0.13 0.44

Duration assets 5.60
76
Liabilities
Short-term commitments 25 1.485 0.40 0.59
Long-term debt issues 38 5.844 0.60 3.51
Duration liabilities 4.10

b. Calculate the value of the asset portfolio and the value of the liability portfolio if there is a general
increase in interest rates of 75 basis points.
 r% 
%  price = - duration  
 (1 + r ) 

Change in value of asset portfolio:

0.0075
% Δ in asset portfolio = -5.60 [ ]
(1 + 0.06 )
= −0.04
= $76million x − 0.04
= −$3,040,000

 Therefore, the value of the asset portfolio will fall to $72,960,000.

Change in value of liability portfolio:

0.0075
% Δ in liability portfolio = -4.10 [ ]
(1 + 0.06 )
= −0.03
= $63million x − 0.03
= −$1,890,000

 Therefore, the value of the liability portfolio will fall to $61,110,000

 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

Chapter 15
5. Importers, exporters, investors and borrowers may all be participants in the FX markets. Explain why each of
these parties would be involved in FX market transactions.
 Firms conducting international trade transactions (importers and exporters):
 Businesses that export goods or services in the international markets generally receive payments in a foreign
currency
 Also businesses that import goods and services need to pay for those goods and services, usually in a foreign
currency
 The dominant currency of international trade is the USD, but other currencies, such as the GBP, JPY and the EUR,
are also prominent
 Typically, an exporter is likely to sell foreign currency received and buy the local currency through an FX market
 Importers have to buy foreign currency in order to pay for their imports.

 Investors and borrowers in the international financial markets:

 Deregulation of the international financial markets has resulted in an enormous increase in the volume of capital
flows around the world.
 Large corporations, financial institutions and governments raise funds in the international capital markets.
 Borrowers with good credit ratings are able to diversify their funding sources in the international capital markets,
such as the euromarkets.
 A large proportion of funds borrowed in the international markets is converted in from the currency borrowed back
into the home currency, using the FX market.
 Other corporations and financial institutions invest overseas; for example, fund’s managers for pension or
superannuation funds will invest a proportion of their investment portfolios in international stocks and debt
securities.
 The fund’s managers need to purchase FX in order to make the investments.
 Dividend or interest payments received by the fund’s managers will be denominated in a foreign currency. The
managers may sell on the FX markets to convert the receipts back into the home currency for distribution to fund
members.
6. Distinguish between speculative and arbitrage transactions in the FX market.
 Speculative FX transactions are motivated by the pursuit of a profit
 The sheer volume of speculative transactions implies that, at times, speculators are able to move the market price of
a currency
 Such transactions are always accompanied by an element of risk
 Arbitrage transactions are possible when price differences appear between markets
 The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more markets to lock-in a risk-
free profit.
 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

7. Describe arbitrage transactions using an example of a triangular arbitrage.

 An arbitrageur will attempt to identify markets in which pricing equilibrium is not fully reflected in the price of a
financial asset. For example, it may be possible to discover a cross-currency price advantage by buying and selling
several foreign currencies in several FX markets at the same time.
 Triangular arbitrage occurs when exchange rates between three or more currencies are out of perfect alignment.
Again, the arbitrageur will simultaneously buy and sell a combination of currencies to take advantage of the price
differences.
 Arbitrage profit opportunities generally do not exist for long. The buy/sell actions of the arbitrageurs bring the
prices back into equilibrium.
8. Outline the features of the main types of contracts that are created in the FX markets, distinguishing between
short-dated, spot and forward transactions.
 An FX transaction is described by its value date, that is, the day that the currency is delivered and settlement is
made.
 Spot transactions—the FX contract value date is two business days from the date of the initial order. The exchange
rate is determined today, but delivery occurs in two business days. For example, a company places an order with an
FX dealer to buy USD1 million at a rate of AUD/USD1.3032 on a Tuesday, then the dealer will deliver USD1
million on the Thursday and the company will pay AUD767 341.93 also on the Thursday.
 Forward transactions—the FX contract value date occurs at a specified date beyond the spot date, for example an
order to sell EUR in three months. Again, the exchange rate is set today that will apply at spot plus three months. If
today is 24 March then the 3-month forward value date will be 26 June, providing that is a business day (if not, the
date will be moved forward to the next business day).
 tod transactions—an FX contract with settlement and delivery today.
 tom transactions—an FX contract with settlement and delivery tomorrow.
9. Using the context of the currency pair USD/JPY, explain the terms base currency, terms currency, direct
quotation and indirect quotation.
 Base currency—the first named currency in an FX quote that is expressed as one unit in terms of the second
currency. In the USD/JPY example the base currency is the USD and is expressed as 1USD will be bought/sold for
the amount of JPY that will be given in the quote.
 Terms currency—the second named currency in the quote, that is, the JPY.
 Direct quotation—when the USD is the base currency of the unit of the quotation as in the USD/JPY example
 Indirect quotation—when the USD is the terms currency and the other currency is the base currency in the
quotation. In that case the above quote would be transposed to JPY/USD.
10. An FX dealer is quoting spot USD/SGD1.2750–56.
(a) Explain from the perspective of the dealer what the FX quote indicates.
 The price maker FX dealer will buy USD1 for SGD1.2750. For the party that has entered into the FX contract
with the dealer they will sell USD1 and receive SGD1.2750
 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

 Also, the dealer will sell USD1 for SGD1.2756; the customer will receive USD1 and pay the dealer SGD1.2756
 The dealer will make a margin of 6 points between its bid and offer transactions.
(b) Transpose the quotation.
 The USD/SGD1.2750–56 is a direct quote; the USD is the base currency
 It is possible to transpose the direct quote to an indirect quote (SGD/USD)
 Rule: reverse then invert.

USD/SGD1.2750–1.2756
Reverse the bid/offer prices
1.2756–1.2750
take the inverse, that is, divide both numbers into 1
SGD/USD0.7839–0.7843
11. A Swiss manufacturer generates receipts in USD from its exports of chocolate to America. At the same time,
the company imports cocoa from Nigeria, incurring commitments in NGN (naira). Rates are quoted at:
USD/NGN 162.2520-29
CHF/USD 1.1310-19
Calculate the CHF/NGN cross-rate.
 It is possible to use two methods to calculate this cross-rate; first transpose the CHF/USD rate to a direct USD/CHF
rate and then use the two direct quote method (see question 6). Alternatively, use the direct and indirect quote
method.
 Crossing a direct and an indirect FX quotation:
 to obtain the bid rate—multiply the two bid rates
 to obtain the offer rate—multiply the two offer rates.
 To determine the CHF/NGN cross rate:
165.2520 x 1.1310 = 183.5070
162.2529 x 1.1319 = 183.6540
CHF/NGN 183.50-65
12. A German importer has entered into a contract under which it will require payment in GBP in one month.
The company is concerned at its exposure to foreign exchange risk and decides to enter into a forward
exchange contract with its bank. Given the following (simplified) data, calculate the forward rate offered by
the bank.
EUR/GBP (spot): 0.8260–67
One-month German interest rate: 4.75% p.a.
One-month UK interest rate: 3.25% p.a.
 The quote is from the perspective of the dealer relative to the base currency.
 FM201 - Financial Institutions & Markets
Tutorial 9 Solutions

 The importer needs to buy GBP therefore it will sell EUR to the dealer. The dealer is therefore buying EUR, so
need to use the bid rate.

where: S = spot rate

Ib = interest rate of base currency
It = interest rate of terms currency

Therefore, based on the above data:

0.8260 [1 + (0.0325 x 30/365)] -1
[1 + (0.0475 x 30/365)]
= -0.0010

= 0.8260 – 0.0010
= EUR/GBP0.8250