A bank has a customer who deposits $10,000 into a 12-month CD that pays 2.5% interest, and at the end of the 12 months, the customer rolls the funds over into another 12-month CD. This continues for five or six years. Next, suppose the bank uses these funds to grant a five-year auto loan on which the bank charges 4% interest. After a couple of years, the interest rate the bank must pay on CDs rises to 3%. This is an example of what phenomenon?

Question

Quizplus · Accepted Answer

Interest rate risk is the risk that arises for banks due to fluctuations in interest rates. In this scenario, the bank is paying more on CDs due to increased interest rates, which can reduce the bank's profit margins on loans that were issued at lower interest rates.

A Bank Has a Customer Who Deposits $10,000 into a 12-Month