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.
Thanks for the long feeback back, BB! Comments below. Big Babbu Wrote: ------------------------------------------------------- > 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. agree with this good summary above. > 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. So you seen any LIBOR rise as earning more interest rate spread, right? > 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. Agree. This is exactly the cap risk with FR CD. > I think where you might be getting confused is > that if rates decrease. Exactly. This is the question in my first post > 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, Ah this is the point I was missing!!! There is still risk with Fixed rate CD, but there is no more cap risk — because any upside with LIBOR will just be viewed gain from larger spread. Thanks again for your patience and the long feedback here. - sticky > but yeah, the bank should do something > on the downside (floor) to protect itself as well.
LOL. I guess I should have read your first question more carefully. No problem. I work in banking so it’s nice to be able to help someone else with one of my stronger areas. And yes, with the Fixed rate CD, as Libor rises you earn more spread up to the cap rate where it maxes out.
Sticky, BB, and CSK It is helpful topic. My opinion might be impratical and naive. It seems to me that the best hedge for cap risk is to use a cap when bank issues CD. When both floating based asset and liability has caps, won’t cap risk be eliminated at all. BB, you worked in banks, how do you think?
tommy2004 Wrote: ------------------------------------------------------- > Sticky, BB, and CSK > > It is helpful topic. My opinion might be > impratical and naive. It seems to me that the best > hedge for cap risk is to use a cap when bank > issues CD. When both floating based asset and > liability has caps, won’t cap risk be eliminated > at all. BB, you worked in banks, how do you think? Buying a cap will also work but this may not be the most cost effective option, giving that caps have premiums associated with them.
Yes, you could do that so long as the difference in cap strikes are the same (or higher on the loan side) as the difference in spread between the floating rate loan and floating rate CD then you would eliminate the cap risk (ie, the loan cap strike would have to exceed the CD cap strike by at least the amount of the difference between the floating rate spreads). That way the downside is also protected as when rates fall the interest rate spread remains the same between the asset and liability. This works in CFAI exam world, but rarely would you use such a structure in the real world.
> Buying a cap will also work but this may not be > the most cost effective option, giving that caps > have premiums associated with them. Very true. Caps are not cheap at all, and if you did structure it the way I said in my last post, the cap purchased on the CD is probably going to be quite a bit more expensive than the cap you would have sold on the loan because the strike rate would have to be substantially lower, thus cutting into your profits. We rarely use caps anymore.
in cfa world, assuming a cap is “expensive”, I guess their answer would be to swap LIBOR (receive floating) and pay fixed. The floating you receive offsets the floating liability you have (if you previously issued floating CDs, for example), but you would lock in the fixed rate (so sometimes will be cheaper than buying a cap, sometimes will be more expensive) I guess it depends on every particular situation