Assume that you manage the interest rate risk position for your bank. Your bank cur- rently has a positive cumulative GAP for all time intervals through one year. You expect that interest rates will fall sharply during the year and want to reduce your bank’s risk position. The current yield curve is inverted with long-term rates below short-term rates.
a. To reduce risk, would you recommend issuing a three-month time deposit and investing the proceeds in one-year T-bills? Will you profit if rates fall during the year?
b. To reduce risk, would you recommend issuing a three-month time deposit and making a two-year commercial loan priced at prime plus 1 percent? Why?