Problem:
Banks are net lenders, when they have excess funds, or net borrowers, when they have future deficits. As any lender or borrower, they cannot eliminate interest rate risk. A variable borrower faces the risk of interest rate rises, whilst a fixed rate borrower faces the risk of paying a fixed rate above declining rates. The exposure of the lender is symmetrical. The consequence is that there is no way to neutralize
interest rate risk.
(i) What do you understand by the terms?
(a) Interest rate gaps
(b) Liquidity Gaps
(c) Term structure of interest rates
(ii) Explain how derivatives can be used to alter interest rate exposures and make interest income independent of rates.