a) Degree of Liquidity of the Assets (10 marks)

Liquidity refers to how quickly an asset can be converted to cash without significant loss in value. In Ghana’s context, under BoG’s Liquidity Risk Management Guidelines, banks prioritize liquid assets for compliance (e.g., high-quality liquid assets per Basel III).

• i. Treasury Bills: Highly liquid. These are short-term government securities (91-182 days) issued by BoG via auctions. They can be sold in secondary markets with minimal price impact, often at face value minus discount. In Ghana, they form part of banks’ reserves post-2019 cleanup, with active trading on the Ghana Fixed Income Market. Liquidity is near-cash, but slightly less than notes due to maturity wait.
• ii. Gilt-Edged Stock: Moderately liquid. These are long-term government bonds (e.g., UK gilts or similar Ghanaian bonds like 10-year notes). Backed by government, low default risk, but liquidity depends on market depth. In Ghana, post-DDEP (2022-2024), bond liquidity dipped due to haircuts, but secondary trading via GSE improves it. Less liquid than T-bills due to longer maturities and interest rate sensitivity.
• iii. Bank Notes: Most liquid. These are physical currency (e.g., Ghana cedis), immediately acceptable for transactions. No conversion needed; they are legal tender per BoG Act. In digital era, mobile money (e.g., MTN MoMo) enhances, but physical notes remain benchmark for liquidity, though inflation erodes value (e.g., 2023 peaks at 54%).
• iv. Certificates of Deposit (CDs): Moderately to low liquid. Issued by banks for fixed terms (3-12 months) at higher rates than savings. Early withdrawal incurs penalties, reducing liquidity. In Ghana, post-2016 Act 930, banks like Stanbic offer them, tradable in secondary markets but with limited buyers. Better than illiquid assets like property, but less than T-bills.

Ranking: Bank notes > Treasury bills > Certificates of deposit > Gilt-edged stock. Liquidity supports banking operations, e.g., during 2020 COVID liquidity injections by BoG.

b) Use of Interest Rate Swap for Managing Interest Rate Risk (10 marks)

Interest rate risk arises from fluctuations in rates affecting borrowing/lending costs. Companies use swaps to hedge, per corporate finance principles in Ghana’s markets.

• Mechanism of an Interest Rate Swap (IRS): An IRS is a derivative where two parties exchange interest payments on a notional principal. E.g., fixed-for-floating: Company A pays fixed rate, receives floating (e.g., linked to BoG policy rate); Company B does opposite. No principal exchange; netted periodically.
• Application for Risk Management:
  • Hedging Variable Rate Debt: A company with floating-rate loan (e.g., tied to prime rate + margin) fears rate rises (e.g., BoG’s 2022-2023 hikes to 30%). It enters fixed-for-floating swap, paying fixed (locking costs) and receiving floating (offsetting loan payments). Net: fixed effective rate.
  • Example: Ghanaian firm like a cocoa exporter borrows at floating 25% (2024 rates). Swaps with bank: pays 20% fixed, receives floating. If rates rise to 28%, receives 28%, pays 20% + (28% loan – 28% received) = effective 20% + loan margin.
  • Hedging Fixed Rate Exposure: If holding fixed-rate assets (e.g., bonds) in falling rates, swap to floating to benefit.
  • Benefits: Reduces volatility, aids budgeting. In Ghana, post-DDEP, firms use IRS via banks like Barclays for Eurobond exposures. Complies with BoG’s risk management directives.
  • Risks and Considerations: Counterparty risk (mitigated by collateral), basis risk if indices mismatch. BoG regulates derivatives under Payment Systems Act, requiring approval for large exposures.

Practical: During 2023 inflation, Ghanaian corporates swapped to fixed rates, stabilizing finances amid BoG’s tightening.