Correlation mock exam

Mock exam

Kaitlyn Brooke has been hired to review the overall management of NALA Bancorp’s financial assets. The investment securities portfolio of a bank is an integral componentof the overall banking enterprise. NALA Bancorp generally offers deposits, small business loans and residential and
commercial mortgages to the local community. NALA has an equity capital ratio of 10%and modified durations of three years for assets and two years for liabilities.
The yield on liabilities is expected to move by 70 basis points for every 100 basis point of yield change in the assets. NALA has concerns regarding the volatility of
shareholders’ capital. Brooke considers two portfolio strategies to help reduce the

Strategy 1: Decrease the correlation between asset and liability value changes.
Strategy 2: Increase holdings of high-quality bond/debt investments

Question is Select the more appropriate strategy to reduce the volatility of shareholders’
equity (Strategy 1, Strategy 2). Explain why the other strategy is less

Answer: Strategy 1 (decrease correlation between assets) is not appropriate. The strategy should be to increase correlation between assets and liability value changes.

How does increasing correlation decrease volatility?

Think of equity as a portfolio: long assets, short liabilities.

An increase in the correlation of asset values and liability values will decrease the correlation between positive asset values and negative liability values.

That’s the point they’re trying to make.

That said, changes in correlation, by themselves, don’t necessarily explain changes in portfolio value. You also have to look at relative volatilities; i.e., you’re interested in covariances, not merely correlations.

It’s not a good question.

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At this point I am starting to conclude that none of the questions in morning session in the mock is a good question. Bill to the rescue again. Thank you

Wisdom feels good, don’t it?