1.If you use only duration to immunize your portfolio, what three factors affect changes in the net worth of a financial institution when interest rates change?

2. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94 years. The assets are financed with equity and a $900,000, two-year, 7.25 percent semiannual coupon capital note selling at par.

a.What is the leverage adjusted duration gap of Financial Institution XY?

b.Using the information calculated in parts (a) and (b), what can be said about the desired duration gap for a financial institution if interest rates are expected to increase or decrease.

3.Hands Insurance Company issued a $90 million, one-year, zero-coupon note at 8 percent add-on annual interest (paying one coupon at the end of the year) or with an 8 percent yield. The proceeds were used to fund a $100 million, two-year commercial loan with a 10 percent coupon rate and a 10 percent yield. Immediately after these transactions were simultaneously closed, all market interest rates increased 1.5 percent (150 basis points).

a.What is the true market value of the loan investment and the liability after the change in interest rates?

b. What impact did these changes in market value have on the market value of the FI’s equity?

c. What was the duration of the loan investment and the liability at the time of issuance?

d.Use these duration values to calculate the expected change in the value of the loan and the liability for the predicted increase of 1.5 percent in interest rates.

e.What is the duration gap of Hands Insurance Company after the issuance of the asset and note?

f. What is the change in equity value forecasted by this duration gap for the predicted increase in interest rates of 1.5 percent?

g.If the interest rate prediction had been available during the time period in which the loan and the liability were being negotiated, what suggestions would you have offered to reduce the possible effect on the equity of the company?  What are the difficulties in implementing your ideas?