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Question 6: Interest Risk Management

You are a financial analyst for a bank that holds a significant portfolio of fixed-rate bonds. The bank is concerned about potential interest rate fluctuations and is considering various interest rate risk management strategies. Calculate and analyze the impact of different strategies on the bank's portfolio value in the event of a change in interest rates.

a. Portfolio Description: The bank holds a portfolio of fixed-rate bonds with a total market value of $10 million. The current yield to maturity (YTM) of the portfolio is 4%, and the duration of the portfolio is 5 years.

b. Scenario 1: Calculate the potential change in the portfolio's market value if interest rates increase by 1%. Assume that the yield curve shifts upward uniformly by 1%, impacting all bond maturities.

c. Scenario 2: Calculate the potential change in the portfolio's market value if interest rates decrease by 0.75%. Assume that the yield curve shifts downward uniformly by 0.75%.

d. Interest Rate Swap: The bank is considering entering into an interest rate swap agreement to mitigate interest rate risk. Calculate the net cash flows from the interest rate swap over the next year if the fixed-rate side of the swap pays 3% and receives the floating rate, which is expected to be 2.5% based on current market conditions.

e. Duration Matching: The bank is also exploring duration matching as a risk management strategy. Calculate the percentage change in the portfolio's market value if the bank adjusts its portfolio to have a modified duration of 5 years to match the current duration.

f. Analysis: Compare the results of the different strategies (Scenario 1, Scenario 2, Interest Rate Swap, and Duration Matching) in terms of their impact on the portfolio's market value in response to interest rate changes. Discuss the advantages and disadvantages of each strategy and provide recommendations for the bank's interest rate risk management.