Asset and Liability Spread Consider the following scenario: As a manager of a fi
ID: 2730731 • Letter: A
Question
Asset and Liability Spread
Consider the following scenario:
As a manager of a finance company, you are attempting to increase the spread between the rate earned on your assets and the rate paid on your liabilities.
(a) Assume that you expect interest rates to decline over time. Should you issue bonds or commercial paper in order to obtain funds?
(b) If you expect interest rates to decline, will you benefit more from providing medium-term fixed rate loans to consumers or floating rate loans to businesses?
Explanation / Answer
Answer:
a) In the given scenario, we have to increase spread between the rate earned on assets and the rate paid on liabilities. When we expect interest rate will be decline over time, we will make profit if we take the advantage of this situation. Commercial paper and bonds are both are the source of fund but commercial paper is short term source of fund while bonds are long term source of fund on which fixed coupon rate is paid. When the company issue the bonds, it will be long term and the payment will also be fixed. So, the company cannot be take more advantage of decreasing interest rate scenario by reducing its liabilities. But if the company issue commercial paper, it will be for short term and if interest rate decrease when the commercial paper get matures, the payment will get reduced and the spread will increase. Further risk on commercial paper is lower than risk on bonds because of maturity period. So, expected return of investor on commercial is lower than bonds.
Thus, the company should issue commercial paper to increase spread.
b) When we expect interest rate will be decline in near future, we can get more benefit providing fixed medium interest rate because our earning will be locked at maturity. If we provide floating interest rate, our earning will not fixed. So, interest will be decline, our earning will be also decline.
Hence we can increase spread to providing medium-term fixed rate loans to consumer rather than providing floating rate loans to businesses.