# Exam 2006: cap risk

Part 2 (second statement) of Q9A, exam 2006. Please refer to the question. According to solution, “a fixed rate CD would eliminate the cap risk” for Corinthian Bank. Why? What if LIBOR falls dramatically? - sticky

cap risk only applies to floating securities. Cap risk is that you are holding float with a cap, so if float rises above cap, you will be at disadvantage

comp_sci_kid Wrote: ------------------------------------------------------- > cap risk only applies to floating securities. Cap > risk is that you are holding float with a cap, so > if float rises above cap, you will be at > disadvantage yes, i know these general stuff. Do you have the question and solution with you? Why can fixed rate CD eliminate the cap risk that Corinthian Bank is particularly facing? - sticky

let me take a look

sticky, they are talking about cap risk. Cap risk in question is the risk that the LIBOR will raise through 300 cap. When it happens rate on CD will rise higher but Loan income wont, creating a shortfall. if Rate falls dramatically it wont be a cap risk, but rather interest rate risk

It’s a bank. The bank is issuing the security to an investor. The bank is paying interest to the investor. If the investor purchase the fixed rate CD your cost of funds is set. On the loan side if rates increase your loan income will halt at the cap rate. If you do the floating rate CD, and interest rates increase the loan income will stop at the cap rate, but the deposit expense will continue to rise as high as the floating rates go. Thus you are facing cap risk on the interest spread income.

csd and Big Babbu, you are describing the problem (cap risk) that the bank is facing but this is not what I am asking. My question is about the last sentence with the solution (please have a read of that): “A fixed rate CD would eliminate cap risk (that the bank is facing)”. Why? I would think there would still be cap risk if the bank issue fixed rate CD. - sticky

Sticky, You need to read my explanation carefully. I believe I’ve explained exactly what you are asking. Note specifically the reference to the cost of funds.

BB i believe sticky is wondering about the exact definition of cap risk.

Here’s the wording right out of Schweser: “If any of the bonds in a portfolio have floating rates, they may be subject to cap risk. As used here, cap risk refers to a cap on the floating rate adjustment to the coupon on a floating rate security. if bonds are subject to caps when interest rates rise, they might not fully adjust and thus would affect the immunization capability of the portfolio.” So if you read this, it does fit into what I was explaining above in a round about way.

comp_sci_kid Wrote: ------------------------------------------------------- > BB i believe sticky is wondering about the exact > definition of cap risk. bb and csk, may be csk is right above What is this cap risk about? The bank fears that interest received from the loan is capped when interest rate rises, so there is risk it cannot pay interest on the debt issued by itself. Now with a fixed-rate CD issued, the bank seems to be happy and says: “look it’s great I don’t have to pay more interest on the CD side even when interest rate is rising”, but my question before this is ---- how can the bank make sure that it is well financed/backed to pay this fixed rate? As an example, I can still see big risk here if the fixed rate is 20% but the loan is only paying capped LIBOR+50bp. Cap risk with the loan will only make the situation worse. (So I see there is STILL cap risk when issuing fixed rate CD) Well, may be it’s all because I don’t understand why the bank should issue CDs in the first hand. Yes, there is cap risk with issuance of floating rate CD, but I don’t see issuing fixed rate CD solving any issue. For the case of fixed rate CD, shouldn’t it have longed an interest rate swap as fixed receiver as well? loan + rx fix swap + issue fixed rate CD will make sense to me. Comments welcome. - sticky

You have to look at a bank in the big picture. Banks make margin (interest rate spread) by offering loans at higher rates than deposits. For example a 5 year fixed rate mortgage may be priced at Govt. Bonds plus 200 bps, while a 5 year fixed rate CD would be priced at Govt. Bonds plus 100 bps. That’s only part of it. They also play the yield curve ( when it is normal - upward sloping). Most fixed rate mortgages go long term, while for the most part deposits go short term. This is why asset liability management is so important for banks - to control interest rate risk. Now, if 5 year fixed rate CD’s were priced at 20% as you mentioned, there’s a good chance LIBOR is going to be way up there as well, and if it’s not, the bank is going to increase it’s spread over LIBOR. It’s not going to lend out money for less than it’s cost of funds. So, in the case of this question, cap risk is directly related to interest rate risk when rates increase. By issuing the fixed rate CD instead of the floating rate CD, when rates increase to the cap rate you have maximized your interest rate spread. If you had issued the floating rate CD, you are exposed to cap risk because the loan income stops at the cap, but the CD expense keeps climbing with floating rate increases. I think where you might be getting confused is that if rates decrease. If rates decrease then your loan income would fall below the fixed rate CD expense you are paying. But that has nothing to do with cap risk, because cap risk is only on the up side. Rates falling is irrelevant to the question, but yeah, the bank should do something on the downside (floor) to protect itself as well.