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In Chapter 9 we have learned that derivatives (an instrument or contract that derives its value from another underlying asset, instrument, or contract) when used prudently can represent a cost- effective means to manage risk. Banks can replicate on-balance sheet transactions with off balance sheet contracts.

The most common interest rate derivatives are:

  • >Interest rate swaps, caps, and floors.
  • >Financial futures contracts
  • >Credit default swaps.

I would like you to pick one of the following situations below and tell me how you might use a derivative to reduce the risk that is faced by the Bank. I would like a good explanation of the derivative that you plan to use and how it will work to solve your bank’s problem.

  1. Associated Bank, National Corporation’s management team has determined that market interest rates are going to decrease rather dramatically. They need for liquidity purposes need to sell a portion of their bond portfolio to meet depositors’ needs for coming quarter. However, the bonds they wish to sell if held for the next few months could be sold for a profit. How could the Bank get their liquidity and profit both?
  2. Citizens Community Federal National Association has interest-sensitive assets of $101 million and has interest-sensitive liabilities of $150 million over the next 30-days and they expect interest rates to increase dramatically. What is the problem that Citizens Community faces with these levels of assets and liabilities? How can they use derivatives to solve the problem?
  3. A survey of First International Bank & Trust corporate loan customers this month (September) indicates that on balance, these loan customers will need to draw $170 million more than the bank’s management has forecasted and is prepared for to happen. The bank’s economist has predicted a significant increase in money market rates over the next sixty days. How can the bank solve the problem using derivatives to solve the problem of derivatives? How would the bank solve the liquidity problem?
  4. First Western Bank & Trust’s recent acquisition has left them with in interest-sensitive assets greater than interest-sensitive liabilities by $24 million. If interest rates should fall (as suggested by their investment analysist), the bank net interest margin may be squeezed due to the decrease in loan and security revenue. How can the bank use derivatives to solve the problems?

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