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). You are 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. Your 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 your 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. / 2 (a) Draw the cashflow ladder for Rural’s interest rate sensitive assets and liabilities. You should use the following time buckets; Time 0 for Call or overnight exposures and then six-monthly buckets up to 4 years (e.g. 6 months, 12 months, 18 months etc XXXXXXXXXXmarks) (b) Using the Zero-Coupon equivalent interest rates calculated from market interest rates shown, in Table 2; calculate the PVBP for each of the “time bucket” cashflows in the Cashflow Ladder and the total PVBP, for all interest rate sensitive assets and liabilities? (10 marks) (c) You are required to undertake an assessment of potential future interest rate changes based on past daily changes in interest rates for each of the “timebuckets” in the Cashflow Ladder, assuming that the assessed interest rate changes for each “timebucket” are independent i.e. uncorrelated. You have decided to base this assessment on the past six months daily changes in interest rates, i.e. from 1 March 2019 to 25 August 2019 and you are required to source the appropriate data. Note; depending on the data you have sourced, you may need to interpolate data to estimate interest rate changes for each “timebucket”. A spreadsheet has been provided to assist with this process. (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) / 3 DATA Table 1 Rural Bank of Australia Limited Balance Sheet as at 26 August 2019 Current $ Current $ Rate Rate %pa %pa Shareholders Funds Short Term Investments Capital 35,900,000 Interbank Call loans XXXXXXXXXX,400,000 Reserves & Retained Earnings 17,500,000 6 month2 Investments XXXXXXXXXX,300,000 Total Shareholders’ Equity 53,400,000 Total Short Term Investments 66,700,000 Deposits & Borrowings Loans - Call Deposits XXXXXXXXXX,800,000 - Overdrafts (daily rate reset XXXXXXXXXX,300, XXXXXXXXXXmonths (180 days XXXXXXXXXX,400, XXXXXXXXXXyear Housing (6mth rate reset XXXXXXXXXX,900, XXXXXXXXXXyears (semi-annual XXXXXXXXXX,900, XXXXXXXXXXyears Corporate (semi-annual XXXXXXXXXX,900, XXXXXXXXXXyears (semi-annual XXXXXXXXXX,800, XXXXXXXXXXyears Corporate (semi-annual XXXXXXXXXX,200, XXXXXXXXXXyears (semi-annual XXXXXXXXXX,500, XXXXXXXXXXyears Corporate (semi-annual XXXXXXXXXX,400, XXXXXXXXXXyears (semi-annual) Debt Issues XXXXXXXXXX,000,000 Total Borrowings 846,400,000 Total Loans 817,700,000 Property, plant and equipment 5,400,000 899,800,000 889,800,000 Table 2 %pa Call 6 months 1 year 1.5 years 2 years 2.5 years 3 years 3.5 years 4 years Par XXXXXXXXXX XXXXXXXXXX 0.67 Zero XXXXXXXXXX XXXXXXXXXX 0.67 Additional Information 1. You have noted that the zero-coupon equivalent interest rates are the same as the PAR rates because the yield curve is relatively flat over the period to 4 years. All of the above interest rates, except Call, are semi-annually compounding interest rates 2. The interest rates shown in the balance sheet are the average interest rates applicable to each of the instrument types and each maturity band in the balance sheet as at the date of the balance sheet. You have assumed for the purposes of the calculations that these rates represent the cost or revenue (as the case may be) for the purposes of calculating cashflows and returns. 3. Rural’s marginal borrowing and lending rates for terms of 6 months are priced or set by reference to the Australian Bank Accepted Bill (BAB) interest rate and at the Commonwealth Government Security (CGS) rate for terns of one year and longer. These are the interest rates reflected in Table 2 above.