In year one,a bank facing reinvestment risk earns 11 percent on its assets and pays 10 percent on its liabilities. In year two,the bank had a negative profit spread of 100 basis points. Which of the following is true? In year two,

Question

Quizplus · Accepted Answer

A negative profit spread means that the bank's cost of funds (10 percent on liabilities) is higher than its asset yield (unknown in year two, but was 11 percent in year one). The difference is 100 basis points, so if we assume the asset yield remained the same in year two, then rates must have fallen 100 basis points (resulting in a lower asset yield) for the profit spread to be negative. Therefore, the correct answer is D, rates fell 200 basis points (100 basis points for the profit spread plus another 100 basis points for the decrease in asset yield).

In Year One,a Bank Facing Reinvestment Risk Earns 11 Percent