Exam - Bank Management

Case Questions for Comerica Incorporated: The Valuation Dilemma

1. What do banks do and how do they make money?

2. Describe (as data allows) how some of the key characteristics for CMA's financial health are calculated in Case Exhibit 5 and what story they tell regarding CMA's potential as an investment for Wilson's portfolio.

3. Should Wilson go long on CMA in his portfolio? Or might a short on CMA be a better strategy? Justify your answers based on your valuation estimates (use case Exhibit 7 as a starting point and other methodologies as appropriate).

Lecture Questions

1. Assume a two-year Euro-note (pays coupon annually), $100,000 par value, an annual coupon rate of 10 percent and convexity of 2.7. If today's YTM is 11.6 percent and term structure is flat,

a. What does convexity measure? Why does convexity differ among bonds? What happens to convexity of bonds when interest rates rise? Why?

b. What is the exact price change in dollars if interest rates increase by 10 basis points (a uniform shift)?

c. Assume the Euro-note is the debt issue of the firm. How should the firm invest the proceeds of the debt issue such that its equity value is immunized against interest rate risk? (i.e. achieve equity dollar duration of zero supposing convexity is ignored).

d. How long is the hedge in part (g) (i.e. the zero duration position) good for? Why? Explain.

2. a. "A ten year zero coupon U.S. Treasury bond is more interest sensitive than a ten year zero coupon corporate bond." Is this statement true, false or uncertain? Explain.

b. "The business of banking can be best described as buying and selling insurance." True or false, explain.

3. Assume that U.S. Treasury decides to extend a loan guarantee (for political reasons) to a country with a B rating. With such a guarantee this country will be able to issue a five-year $2 billion face value zero-coupon bond at a yield of 7.5 percent (annual compounding). Assume that the yield on a similar maturity U.S. Treasury bond and a B rating sovereign debt is 7.5 and 8.5 percent, respectively.

Does this loan guarantee have any implicit cost on the U.S. taxpayers and if so how much?

4. The following is the market-value balance-sheet for the First Bank. The required return on net worth is now 15 percent. All income is received at the end of the year and is reinvested in the bank.

a. Calculate the Funds Gap

b. Calculate expected annual pretax profits given the above information.

c. Calculate the present value of this year's expected additions to net worth.

d. Suppose that the yield curve shifts up by 3 percent (All rates go up by 3 percent including the required return on net worth). Calculate expected pretax profits and the present value of expected additions to net worth.

e. Is this institution free from interest-rate risk? Briefly explain.

5. (20 points) You are given the following information about Ventures Stores in the table below.

a) Assuming Ventures Stores Inc was far from default at the end of June 1994, estimate the market value of its assets and volatility of assets using the KMV approach. (Hint: What values do probabilities N(d1) and N(d2) approximately take, if default is not probably to occur within 12 months?)

b) Market expectations about the financial health of Venture Stores Inc. was quite different in June 1996. Given the values of the market value of assets and volatility of assets shown in the table what was the distance from default (in σ unit)

c) Given the information you obtain in part b find the probability of default at the end of June 1996?

d) Briefly explain how KMV Corporation makes use of its large database to calculate the Empirical Default Frequency for a publicly traded company

Attachment:- comerica-incorporated.pdf