Module: | MODULE B: RISK MANAGEMENT
Q369: Scenario: ABC Bank has funded a massive portfolio of 10-year fixed-rate retail loans by heavily relying on short-term floating-rate wholesale deposits linked to the central bank's repo rate. The Asset Liability Management Committee (ALCO) anticipates a severe macroeconomic shock leading to a sharp hike in policy rates.
To explicitly mitigate this structural basis and yield curve risk, which specific Interest Rate Swap (IRS) strategy should the ALCO execute?
✅ Correct Answer: B
The correct answer is B. The bank is currently "liability-sensitive," meaning its liabilities reprice faster than its assets.
It receives fixed-rate interest (from the loans) and pays floating-rate interest (on the deposits). If interest rates rise, its funding costs will surge while its income remains stagnant, compressing the Net Interest Margin (NIM). To hedge this, ALCO must execute an Interest Rate Swap (IRS) where the bank Pays a Fixed Rate (offsetting its fixed loan income) and Receives a Floating Rate.
The floating rate received from the swap counterparty will naturally match and cover the rising floating-rate costs of its wholesale deposits.
Option A (Pay Floating, Receive Fixed) would be suicidal, doubling down on the exact risk they are trying to hedge.
Options C and D are extreme and impractical alternative actions, not standard IRS hedging strategies.
It receives fixed-rate interest (from the loans) and pays floating-rate interest (on the deposits). If interest rates rise, its funding costs will surge while its income remains stagnant, compressing the Net Interest Margin (NIM). To hedge this, ALCO must execute an Interest Rate Swap (IRS) where the bank Pays a Fixed Rate (offsetting its fixed loan income) and Receives a Floating Rate.
The floating rate received from the swap counterparty will naturally match and cover the rising floating-rate costs of its wholesale deposits.
Option A (Pay Floating, Receive Fixed) would be suicidal, doubling down on the exact risk they are trying to hedge.
Options C and D are extreme and impractical alternative actions, not standard IRS hedging strategies.