A commercial bank calculates that the duration of its liabilities (excluding net worth) averages 1 year while the duration of its assets averages 5 years. Assume that this bank has $100mn of assets and $25mn of capital. Also assume that assets and liabilities (excluding net worth) are interest rate sensitive and enter the balance sheet at market value (marked to market).
a) If interest rates rose by 2% (200bp) what would happen to the value of this bank's assets and this bank's debt?
b) Further to your answer above, what happens (numerically) to this bank's leverage ratio?
c) If the bank wanted to neutralise (immunise) the impact of interest rate shifts through the futures market, should it buy or sell interest rate futures?
d) On the assumption that the bank deals in 3mth Eurodollar futures with one contract having a principal value of $1mn, how many contracts would be needed for full hedging?