APPLICATION Strategies for Managing Interest-Rate Risk Suppose that as the manager of the First Bank, you have done a duration and gap analysis for the bank as discussed in the text. Now you need to...

APPLICATION Strategies for Managing Interest-Rate Risk

Suppose that as the manager of the First Bank, you have done a duration and gap analysis for the bank as discussed in the text. Now you need to decide which alternative strategies you should pursue to manage the interest-rate risk. If you firmly believe that interest rates will fall in the future, you may be willing to take no action because you know that the bank has more rate-sensitive liabilities than rate-sensitive assets and so will benefit from the expected interest-rate decline. However, you also realize that the First Bank is subject to substantial interest-rate risk because there is always a possibility that interest rates will rise rather than fall. What should you do to eliminate this interest-rate risk? One thing you could do is to shorten the duration of the bank s assets to increase their rate sensitivity. Alternatively, you could lengthen the duration of the liabilities. By this adjustment of the bank s assets and liabilities, the bank s income will be less affected by interest-rate swings. One problem with eliminating the First interest-rate risk by altering the balance sheet is that doing so might be very costly in the short run. The bank may be locked into assets and liabilities of particular durations because of where its expertise lies. Fortunately, recently developed financial instruments known as financial derivatives financial forwards and futures, options, and swaps can help the bank reduce its interest-rate risk exposure but do not require that the bank rearrange its balance sheet.