1.What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk?
2.What isrefinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of interest?
3.What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest?
4.How can interest rate risk adversely affect the economic or market value of an FI?
5.Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zero-coupon bond that pays only a lump-sum payment after 10 years with no interest over its life. Which bond would have more interest rate risk? That is, which bond’s price would change by a larger amount for a given change in interest rates? Explain your answer.
6.Consider again the two bonds in problem 9. If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this risk?
7.What is market risk? How does this risk affect the operating performance of financial institutions? What actions can be taken by FI management to minimize the effects of this risk?
8.What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
9. A financial institution has the following market value balance sheet structure:
Assets Liabilities and Equity
Cash $1,000 Certificate of deposit $10,000
Bond $10,000 Equity $1,000
Total assets $11,000 Total liabilities and equity $11,000
a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year? Note: Net interest income equals interest income minus interest expense.
b.If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?
c.Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends.
d.If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why?
e.What factors have caused the changes in operating performance and market value for this firm?
10.A bank invested $50 million in a two-year asset paying 10 percent interest per year and simultaneously issued a $50 million, one-year liability paying 8 percent interest per year. The liability will be rolled over after one year at the current market rate. What will be the bank’s net interest income if at the end of the first year all interest rates have increased by 1 percent (100 basis points)?