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 $$\begin{array} { | c | c | }
\hline \text { Assets } & \text { Liabilities } \
\hline \text { 1-year loan rate: } 7.50 \text { percent } & \text { 1-year CD rate: } 6.50 \text { percent } \
\hline \text { 2-year loan rate: } 8.15 \text { percent } & \text { 2-year CD rate: } 6.65 \text { percent } \
\hline
\end{array}$$
-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.
E)There is no interest rate risk exposure.

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 $$\begin{array} { | c | c | } 
\hline \text { Assets } & \text { Liabilities } \
\hline \text { 1-year loan rate: } 7.50 \text { percent } & \text { 1-year CD rate: } 6.50 \text { percent } \
\hline \text { 2-year loan rate: } 8.15 \text { percent } & \text { 2-year CD rate: } 6.65 \text { percent } \
\hline
\end{array}$$
-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.
E)There is no interest rate risk exposure.

Quizplus · Accepted Answer

The optimal transaction involves funding a 2-year loan with a 1-year CD, and then funding a 1-year loan with a 2-year CD which will mature in one year. Therefore, the FI is exposed to the risk that interest rates will rise in one year, when they will need to sell the 1-year CD to fund the 1-year loan. If interest rates rise, the FI will need to sell the CD below market value, resulting in a loss.

The Following Information Is About Current Spot Rates for Second