Peoples Bank Ltd.

Balance sheet

As at 31/03/2021

Assets $(000) Liab. & Equity $(000)

Cash 50,000 Payables 50,000

Short term Invest 50,000 short term deposits 500,000

Long term Invest. 180,000 long term deposits. 180,000

Loans 550,000 Long-term bonds 50,000

Other 50,000 Equity 100,000

Total 880,000 880,000

The long-term investment portfolio comprises shares in an associate company (25%), a zero-coupon bond (25%), government fixed rate bonds (40) and shares in publicly traded companies (10%).

The loan portfolio is composed as follows: 10% residential mortgages, 50% consumer and 40% commercial. The loan portfolio has a 5% delinquency, and the average return is 8%. Fixed rate loans are 60% and floating rate 40%.

Deposits are primarily short term. The renewal rate is declining and expected to continue into the medium term. The average deposit rate is 4%.

Interest rates are expected to rise in the short term for both, loans and deposits.

A. Based on the balance sheet and the information above, identify three risks facing the bank? Explain. (6 marks)

B. Recommend to management two strategies to reduce each risk (9 marks)

C. Discuss the bank's capital adequacy based on the information given (5 marks)

PART B (10 marks)

A large corporate customer approaches your bank for a US$10 million loan at a fixed rate of 6% p.a. over five years to acquire equipment. Interest to be paid annually, principal at maturity. Your bank has adequate USD funding priced at 3 months libor (3ML). Based on the economic recovery and reopening of major economies after the covid-19 vaccines, the bank is concerned about rising interest rate and the USD exchange rate. The proposal is attractive at current rates and the bank is willing to underwrite the loan providing it can hedge the interest rate risk.

The bank has a swap party that is interested in receiving 6% and paying 3 months libor plus 2%.

A. With the aid of a diagram, show how this USD loan can be hedged using a swap. (5 marks)

B. What is the net interest income/year to the bank from the hedge facility in (A) above?

3

(2 marks)

C. What will be the net interest income to the bank on the hedged facility if interest rates (3ML) increase by 200 basis points? (3 marks)