EDF Bank has a very simple balance sheet. Assets consist of a two-year, $1 million loan that

Question:

EDF Bank has a very simple balance sheet. Assets consist of a two-year,

$1 million loan that pays an interest rate of LIBOR plus 4 percent annually.

The loan is funded with a two-year deposit on which the bank pays LIBOR plus 3.5 percent interest annually. LIBOR currently is 4 percent, and both the loan and the deposit principal will be paid at maturity.

a. What is the maturity gap of this balance sheet?

b. What is the expected net interest income in year 1 and year 2?

c. Immediately prior to the beginning of year 2, LIBOR rates increase to 6 percent. What is the expected net interest income in year 2? What would be the effect on net interest income of a 2 percent decrease in LIBOR?

d. What do the answers to parts

(b) and

(c) of this question suggest about the use of maturity gap to immunize an FI against interest rate risk?

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Daniel Wangare

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