A bank with a two-year horizon has issued a one-year certificate of deposit for $50 million at an interest rate of 2 percent. With the proceeds, the bank has purchased a two-year Treasury note that pays 4 percent interest.

1. What risk does the bank face in entering into these transactions?

The bank runs the danger that just before the second year, the short-term interest rate will increase, increasing its Lending value, but leaving untouched the interest income the bank gets from either the Treasury bill.

Annual interest revenue of 0.04 * $50 million = 2 million and annual interest costs for the bank (0.02) * $50 million = 1 million, between 2 per cent to 4 per cent for the Treasury note.

The bank makes a profit of $2 million - $1 million = $1 million. If the interest rate rises 1 percent, the bank's profit falls to

((0.04) * $50 million) - ((0.03) * $50 million) = $500,000.