Chapter 8

Question 1

What is repricing

Answer 1

When the loan or asset changes as soon as interest rates change
(ex: floating mortgage rate)

Question 2

Who sets the interest rates?

Answer 2

BOC and central bank

Question 3

Name 4 4 instruments that change with interest rates

Answer 3

-Consumer price index (CPI)
-Overnight Rate
-Bank rate
-Operating band

Question 4

What is the consumer price index (CPI)

Answer 4

A measure of cost of living that gathers the price of a specific “basket of goods” and compares that price to previous prices of good from previous years

Question 5

What is the overnight rate

Answer 5

The rate that banks in Canada charge each other to borrow usually for a day or two until liquidity is restored

Question 6

What is the bank rate

Answer 6

The rate charged by BOC to FI’s to borrow overnight

Question 7

What is the operating band

Answer 7

It is a certain bandwith or wiggle room that banks charge each other. The range is 0.5% wide, where the bottom of the band is the rate set by BOC on deposits and the top of the band being the rates charged on loans by the BOC on loans

Question 8

What is another word for the supply curve? why?

Answer 8

The yield curve. Because the money comes into play in that manner, as interest rates go up, there’s more supply of money available (since demand is down)

Question 9

Draw and name key characteristic of a NORMAL yield curve

Answer 9

Interest rates in the short term are lower than the interest rates in the long term

Question 10

Draw and name key characteristics of a INVERTED yield curve. What is the goal of the central bank with this type of yield curve?

Answer 10

-Doesn’t tend to stay this way for a long period of time (weeks, months, maybe a few years). Interest rates start high and go lower in the longer term (borrow for one day has more YTM than borrowing for 30 years). This yield curve brings in high inflation.

-The goal is to kill the economy in the short term but those who want to do long term borrowing, do so and by the demand increasing on those long term borrows, the YTM then starts to go up allowing for the yield curve to look normal again

Question 11

Draw and name the second type of INVERTED yield curve that exists. What are some key characteristics?

Answer 11

Interest rates slowly start to go up until the central bank reaches their target. Once this is done the borrowing at the long term is cheaper which increases the demand of long term borrowing, leading to eventual higher interest rates to bring back the normal yield curve

Question 12

Draw and name the FLAT yield curve that exists. What are some key characteristics?

Answer 12

-Bad sign for an economy which could stay like this for a long time.
-Borrowing in the short term is the same YTM as borrowing in the long term
-Hardest economy to turn around

Question 13

What is real interest rates?

Answer 13

Interest rates earned after inflation. If nominal interest rate = inflation, then the real interest rate is 0)

Question 14

What is the formula for real interest rates?

Answer 14

Real = Nominal - rate of inflation

Question 15

Do FI’s have re-priceable assets or re-priceable liab? or both?

Answer 15

They have both

Question 16

*When does profitability or revenue for a FI get affected

Answer 16

-When interest rates go up and down (immediately) on re-priceable assets or liabilities.
-At maturity of the fixed interest rates because at this maturity the assets and liab may no longer be worth the same thus bringing in interest rate risk

Question 17

*What is repricing gap? How is it calculated?

Answer 17

It is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability.

Calculated by doing: RSA - RSL

Question 18

Depending if you have more assets or liabilities at the moment that interest rates change, what comes into play?

Answer 18

Re-financing (short on liab) and re-investment (short on assets) risk

Question 19

How does re-pricing risk gap work?

Answer 19

They separate the assets and liab into buckets classified by their maturity. They then evaluate the gap between these assets and liab per bucket

Question 20

What does it mean if there exist a negative cumulative gap?

Answer 20

It means that liab > assets which is a re-investment risk

Question 21

What does it mean if there exist a positive cumulative gap?

Answer 21

It means that liab < assets which is a re-financing risk

Question 22

What is the goal for a FI to have at the bottom of their cumulative gap?

Answer 22

To have a cumulative gap of zero which would mean that assets and liab are equal

Question 23

Which bucket is the demand deposits placed in?

Answer 23

Into the one day gap

Question 24

What do FI’s chase in terms of re-investment risk?

Answer 24

The banks chase/want short term liabilities and long term assets because of the normal yield curve (where short term interest is lower than longer term interest)

Question 25

*If there is a positive gap (A>L) and rates go up, what happens to NII?

Answer 25

NII goes up

Question 26

*If there is a positive gap (A>L) and rates go down, what happens to NII?

Answer 26

NII goes down

Question 26

*If there is a negative gap (A<L) and rates go up, what happens to NII?

Answer 26

NII goes down

Question 26

*If there is a negative gap (A<L) and rates go down, what happens to NII?

Answer 26

NII goes up

Question 27

*In the one-day bucket, gap is -$10million. If rates rise by 1%, calculate the NII

Answer 27

NII = (-10million) x 0.01
= -$100,000

Question 28

*In the one-year bucket, gap is -$15million. If rates increase by 1%, what happens to NII

Answer 28

NII = (-$15 million) x 0.01
=-$150,000

Question 29

*If assets are equal to $90 million and liab equal to $70 million. One day, rates rise on the assets by 1.2% and rise by 1% on liab. calculate the change in NII

Answer 29

NII = ($90 million x 1.2%) - ($70 million x 1.0%)
= ($1,080,000 - $700,000)
=$380,000

Question 30

How can a FI restructure assets and liabilities?

Answer 30

They can offer promotions (ex: higher interest rates) on either the assets or liabilities side in order to address this discrepancy

Question 31

Name the 4 weaknesses of re-pricing model

Answer 31

-Market value effects (ignore of TVM)
-Over aggregation
-Ignores effects of runoffs
-Ignores market value effects and off-balance sheet cash flows

Question 32

What is market value in the weaknesses of re-pricing model

Answer 32

Ignoring TVM in the re-pricing model

Question 33

What is over aggregation in the weaknesses of re-pricing model

Answer 33

As much as the balance sheet balances at the bottom, this looks at the day to day (each bucket) risk distribution or unbalance.

Question 34

What is “ignores effects of runoffs” in the weaknesses of re-pricing model

Answer 34

They are the re-investment into either higher or lower interest rate situations
(ex: if rates go up on a on mortgages, then the customer will pay the bank more every month which allows the bank to go invest this surplus at a higher or lower interest rate where they can make even more money on the fact that rates increased)

Question 35

What is “Ignores market value effects and off-balance sheet cash flows” in the weaknesses of re-pricing model

Answer 35

Maturity schedule does not take into account the off balance sheet risks like line of credit and more, which is a major weakness

Question 36

What does it mean to be “immunized”

Answer 36

When assets = liabilities, when two risks offset each other

Question 37

*If cumulative maturity gap is equal to zero, does it mean the FI is immunized? Why?

Answer 37

No it doesn’t mean they are immunized since there is a difference in duration (maturity)