Question

Assume a Financial Institution issues 100,000,000 of liabilities (borrow/deposits) with a one year maturity to fund100,000,000 of assets (loans) with a two year maturity. Year 1: Cost of liabilities = 9 Year 1: Return on assets = 10 What happens if all interest rates rise in year two by 3

Answer 1

If all interest rates rise by 3% in year 2, the cost of liabilities would be 12 and the return on assets would be 13.

Step-by-step explanation:

In this scenario, the financial institution has issued liabilities (borrow/deposits) with a one-year maturity period to fund assets (loans) with a two-year maturity period. In year 1, the cost of liabilities is 9, and the return on assets is 10.

If all interest rates rise by 3% in year 2, it means that the interest rate on the liabilities and assets will increase by 3%. Therefore, the cost of liabilities in year 2 would be 12 (9 + 3), and the return on assets would be 13 (10 + 3).

This increase in interest rates in year 2 might impact the financial institution's profitability, as the cost of liabilities would exceed the return on assets. This means that the institution would be paying more in interest to depositors than it is receiving from borrowers, which is not sustainable in the long term.