The following information is about current spot rates for Second Duration Savings' assets (loans) and liabilities (CDs). All interest rates are fixed and paid annually.
-What is the interest rate risk exposure of the optimal transaction in the previous question over the next 2 years?
A)The risk that interest rates will rise since the FI must purchase a 2-year CD in one year.
B)The risk that interest rates will rise since the FI must sell a 1-year CD in one year.
C)The risk that interest rates will fall since the FI must sell a 2-year loan in one year.
D)The risk that interest rates will fall since the FI must buy a 1-year loan in one year.

Question

The following information is about current spot rates for Second Duration Savings' assets (loans) and liabilities (CDs). All interest rates are fixed and paid annually. 
-What is the interest rate risk exposure of the optimal transaction in the previous question over the next 2 years?
A)The risk that interest rates will rise since the FI must purchase a 2-year CD in one year. 
B)The risk that interest rates will rise since the FI must sell a 1-year CD in one year. 
C)The risk that interest rates will fall since the FI must sell a 2-year loan in one year. 
D)The risk that interest rates will fall since the FI must buy a 1-year loan in one year.

Quizplus · Accepted Answer

The FI's optimal transaction involves purchasing a 2-year loan and selling a 1-year CD. This means that in one year, the FI will need to sell the 1-year CD at the prevailing interest rate. If interest rates have risen, the FI will have to sell the CD at a lower price, resulting in a loss. Therefore, the interest rate risk exposure of the optimal transaction is the risk that interest rates will rise. Choice A is incorrect because the FI is purchasing the 2-year loan, not a CD. Choice C is incorrect because the FI is selling a 1-year CD, not a 2-year loan. Choice D is incorrect because the FI is not buying a 1-year loan.

The Following Information Is About Current Spot Rates for Second