Question

Assume a Financial Institution borrows $100,000,000 at 9% for two years and invests $100,000,000 at 10% for one year. What happens if all interest rates in year two fall by 3%?

Answer 1

If all interest rates in year two fall by 3%, the financial institution would owe $11,810,000 more than it earns.

Step-by-step explanation:

When a financial institution borrows $100,000,000 at 9% for two years, it will owe a total of $118,810,000 ($100,000,000 + $18,810,000 in interest). On the other hand, when it invests $100,000,000 at 10% for one year, it will earn $10,000,000 in interest, resulting in a total of $110,000,000.

If all interest rates in year two fall by 3%, the borrowed amount of $100,000,000 will still need to be paid back in full. However, the investment of $100,000,000 will only earn $7,000,000 in interest instead of $10,000,000, resulting in a total of $107,000,000.

Therefore, after the change in interest rates, the financial institution would owe $11,810,000 more ($118,810,000 - $107,000,000) than it earns, which reduces its profit.