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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A bank's ALCO notes that its loan book is mostly long-term fixed-rate, funded by short-term deposits, so net interest income falls when rates rise. Which use of the investment portfolio best serves the objective of managing interest rate risk?

The bank should tilt the portfolio toward short-term or floating-rate securities. This makes assets reprice more quickly, offsetting the liability sensitivity created by long fixed-rate loans funded with short deposits. Buying long-duration fixed securities would widen the repricing mismatch and make net interest income more vulnerable.

  1. ABuy long-duration fixed-rate securities to increase asset duration
  2. BShift toward short-term or floating-rate securities to shorten asset repricing and reduce the gapCorrect
  3. CSell all securities and fund more fixed-rate loans
  4. DBuy securities solely based on highest coupon regardless of maturity

Explanation

The bank is liability-sensitive: assets reprice slower than liabilities. Adding short or floating-rate securities makes assets reprice faster, offsetting the exposure. Long-duration fixed securities worsen it.

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