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Question
A $995 million bank has a negative repricing gap equal to 6% of assets. The bank is currently paying 4.5% on its rate-sensitive liabilities. These rates will vary as interest rates move. The managers wish to reduce the effective repricing gap to zero with an interest rate cap or floor. A one-year cap is available with a 5% cap rate and a one-year floor is available at a floor rate of 4%.
a) Suggest a position using either the cap or the floor (but not both) that will limit the bank's interest rate risk. Explain.
b) Suppose that interest rates are volatile this year and the cap costs $275,000 and the floor costs $195,000. Suggest a collar that helps limit the bank's cost of hedging. How does the collar affect the bank's risk?
Answer
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