A bank with a two-year horizon has issued a one-year certificate of deposit for $60 million at an interest rate of 1 percent. With the proceeds, the bank has purchased a two-year Treasury note that pays 3 percent interest. What risk does the bank face in entering into these transactions?
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Explanation:
Annnual Interest Income = 60 million * (1+3%) - 7million
= 1.8million
Annual Interest Expense = 70 million * (1+1%) - 70 million
= 0.6 million
Profit = 1.8 million - 0.6 million
= 0.2million
If all interest rates were to rise by 1 percent, that essentially means the spread between Treasury note interest and CD interest remains the same as both the interest rates are increasing by 1 percent equally. Therefore, there won't be any effect on the profit of the bank.
If interest rate rise 1 percent, bank's profit in the second year falls to = 60 million *(3%-2%)
= 0.6 million