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The Question

The Balance Sheet for Rural Bank Australia Limited (Rural) as at 26 August 2019 is shown

below as Table 1. Rural is an Authorised Depository Institution in Australia and operates

both retail, corporate and agricultural banking operations in Australia. Rural’s assets and

liabilities are exclusively domiciled in Australia and hence it does not have any foreign

exchange risk.

You are Rural’s Head of Interest Rate Management. You have identified the current market

interest rates applicable to the bank’s assets and liabilities and calculated the zero-coupon

equivalent yields using bootstrapping, and they are set out in (Table 2).

Required to write a Report for Management addressing the questions set out below

and provide your recommended strategies to manage the Bank’s interest rate risks as at 26

August 2019.

The intended audience for your report is the senior management team of your bank. Report should include an Executive Summary (of no more than one page) which means that

your main points and findings are given at the start. Sub-headings in the report are a good

idea to maintain structure. Your style should be professional and succinct and contain

supporting reasons for your conclusions. It is essential that your answer contain supporting

tables, graphs and/or diagrams and that these should be embedded/wrapped in the text.

The calculations performed should be shown as an Appendix to Report.

Question 1 (60 marks in total)

You have been asked to prepare a Report to Management on the current risk profile of

the bank.

(15 marks)

(i) The Bank’s policy is to assess its risk using a 95% confidence level

based on an assumption of that future interest rate changes are normally

distributed. What is the PAMY for each “timebucket” and the bank’s

DEAR?

(ii) Rural’s policy also requires its risk to be assessed over a 10-day time

horizon. What is the Bank’s Value at Risk (VaR)?

(iii) You should explain the approach that you used, the assumptions that

were made to obtain and derive the data and the results and any

limitations that you consider exist with the approach or the methodology

used. You should also include the workings for this calculation as an

Appendix to your paper. (25 marks)

  (d) You have been asked to explain to Management what the results in (a) to (c) above reveal about Rural’s interest rate exposure. You should also explain how the analysis that you have undertaken will assist you in the management of the bank’s risk. (10 marks)

Question 2 (40 marks total)

The Bank’s Head of Markets considers that the current monetary policy environment is

such that “call” or overnight interest rates are likely to fall from the current levels in the

near term, but the outlook for longer-term interest rates is much less clear. This has led

the Head of Markets to form the view that the shape of the yield curve in the future is

likely to be volatile.

You have been asked to develop a strategy to manage the risks of changes in the value

of the portfolio as a result of the potential future interest rate changes. You are also

required to include the following in your Report for Management:

(a) The specific action, if any, that you would recommend be taken, which may

include the use of transactions involving the derivative instruments and/or

action to restructure the balance sheet; (15 marks)

(b) Show the impact of them on the Bank’s risk profile that you have assessed

in Question 1, (15 marks); and

(c) Give the reasons for your recommended strategy and, if applicable, any

assumptions that you have made (and why you made them) on which to base

your recommendations; (10 marks)

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