QUESTION TWO Consider the following balance sheet of Mbazo:

Assets (K) Duration Liabilities (K) Duration

Variable-rate mortgages 1600 4.1 Money market deposits 2000 1.3

Fixed-rate mortgages 1400 8.1 Savings deposits 3500 2.3

Commercial loans 5000 3.2 Variable-rate CDs (>1 year) 1000 1.2

Physical capital 2000 Equity 3500

Total 10000 Total 10000

(a) Using basic gap analysis, calculate the change in net interest income at the year-end if interest rates are forecast to increase by 0.5 per cent, from 3 to 3.5 percent.

Make the following assumptions on the runoff of cash flows:

fixed-rate mortgages repaid during the year: 10 percent;

proportion of savings deposits and variable-rate CD that are rate-sensitive: 20 per cent. (10 marks)

(b) Calculate the duration gap for Mbazo. (4 marks)

(c) Explain how Mbazo could decrease its duration gap. (4 marks)

(d) Explain how gap analysis is used in managing interest rate risk and critically examine its limitations.