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 was the duration gap of Hands Insurance Company after the issuance of the asset and note?

f. What was 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?