Assume that a bank obtains most of its funds from large CDs with a five-year maturity. Its assets are in the form of loans with rates that adjust every six months. The bank would be ____ affected if interest rates decline. To partially hedge its position, it could ____ interest rate futures contracts.

Question

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The bank would be adversely affected if interest rates decline because its funding costs (interest paid on CDs) are fixed, while the income from its assets (interest received from loans) would decrease as the rates on loans adjust downward. To hedge against declining interest rates, the bank could purchase interest rate futures contracts, which would increase in value as interest rates fall, offsetting the reduced income from its adjustable-rate loans.

Assume That a Bank Obtains Most of Its Funds from Large