Module: | MODULE B: RISK MANAGEMENT
Q299: Scenario: A sudden macroeconomic shock hits the country, causing the central bank to hike interest rates by 200 basis points, while the domestic currency depreciates sharply. XYZ Bank holds a large portfolio of fixed-rate corporate bonds in its trading book, and has issued numerous floating-rate foreign currency loans to unhedged importers. Consider the following statements regarding the resultant risk impacts on XYZ Bank:
1. The sudden 200 basis point hike in interest rates, will immediately trigger severe general market risk losses on the fixed-rate corporate bonds held in the trading book.
2. The depreciation of the domestic currency increases the credit default risk of the unhedged importers, indirectly impacting the bank's asset quality.
3. The bank's net interest income (NII) will remain entirely unaffected, because the foreign currency loans are issued on a floating-rate basis.
Which of the statements given above is/are correct?
2. The depreciation of the domestic currency increases the credit default risk of the unhedged importers, indirectly impacting the bank's asset quality.
3. The bank's net interest income (NII) will remain entirely unaffected, because the foreign currency loans are issued on a floating-rate basis.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: An aggressive, macroeconomic interest rate hike universally depresses the prices of existing fixed-rate bonds.
Since these are in the Trading Book, they are marked-to-market daily, meaning the bank will instantly record a massive General Market Risk loss in its P&L. Statement 2 is correct: When the domestic currency depreciates, unhedged importers must spend more domestic currency to buy the foreign currency needed to service their loans.
This severely strains their cash flows, dramatically increasing their probability of default (Credit Risk). Statement 3 is incorrect: While floating-rate loans theoretically protect against interest rate risk by repricing upward, a massive 200 bps hike combined with currency depreciation often forces borrowers into default.
If borrowers default and the loans become NPAs, the bank ceases to accrue interest, which severely and negatively impacts the Net Interest Income (NII).
Since these are in the Trading Book, they are marked-to-market daily, meaning the bank will instantly record a massive General Market Risk loss in its P&L. Statement 2 is correct: When the domestic currency depreciates, unhedged importers must spend more domestic currency to buy the foreign currency needed to service their loans.
This severely strains their cash flows, dramatically increasing their probability of default (Credit Risk). Statement 3 is incorrect: While floating-rate loans theoretically protect against interest rate risk by repricing upward, a massive 200 bps hike combined with currency depreciation often forces borrowers into default.
If borrowers default and the loans become NPAs, the bank ceases to accrue interest, which severely and negatively impacts the Net Interest Income (NII).