Question 1 

A nancial institution has the following balance sheet:

Assets Liab. and Equity

Cash 500 Certicate of deposit 5,000

Bond 5,000 Equity 500

Total assets 5,500 Total liab. and equity 5,500

1. (3) The bond has a 5-year maturity, a coupon of 7 percent paid annually, and a par value of $5,000. The certicate of deposit has a 1-year maturity and a 3 percent xed rate of interest. Assuming that the balance sheet does not change, what is the net interest income at the end of the rst year?

2. (3) At the end of year 1, the rates rise (parallel shift) by 200 basis points (2 percent). What will the net interest income be for the second year?

3. (4) Assuming the same rise in interest rates, what is the value of the bond at the end of year 1? How will this aect is the market value of the equity?

4. (2) If rates lowered, would the operating performance of the FI be better or worse? Hint: Think about equity value and net interest income eects.

5. (2) What type of interest rate risk is this FI facing? (Hint: two-word phrase is sucient.)

Question 2 

A nancial institution has the following balance sheet:

Assets Avg. Rate Liab. and Equity Avg. Rate Rate sensitive 150,000 6.50 Rate sensitive 175,000 4.25 Fixed rate 300,000 7.00 Fixed rate 275,000 6.00 Nonearning 50,000 Nonpaying 50,000

Total 500,000 Total 500,000

1. (3) Suppose interest rates rise such that the average yield on rate-sensitive assets increases by 50 basis points and the average yield on rate-sensitive liabilities increases by 25 basis points. Calculate the bank's repricing GAP.

2. (3) What is net interest income over the next two years if the interest rates on RSAs increase 75 basis points and on RSLs increase 50 basis points?

Question 3 

1. (6) Name three main players that helped cause the nancial crisis. How did each con-tribute? Only need 1-2 sentences on each cause.

2. (4) Name two reasons why a credit union can oer lower loan rates and higher deposit rates.

3. (4) Pay xed swaps versus receive xed swaps: which is asset sensitive and which is liability sensitive? Why?

4. (4) What are two advantages of using derivatives to manage interest rate risk?

5. (3) Why is risk management described as \an art as much as a science" by one of the senior ocers at Well eet?

Question 4 

Use the following table of rates and expected one-year rates (forward rates) to answer part 1 and part 2:

Part 1 Part 2

Treasury Strips Treasury Strips BBB-rated bonds

Period Rate Period Rate Rate

r1 5.0% r1 4.1% 5.3%

E2(r1) 7.0% E2(r1) 5.2% 7.1%

E3(r1) 7.5% E3(r1) 5.8% 8.3%

1. (4) Based on expectations theory, calculate the current rates for two- and three-year-maturity Treasury securities.

2. (6) Using the columns to the right, calculate the term structure of default probabilities over three years using the following spot rates from the Treasury strip and corporate bond (pure discount) yield curves. Be sure to calculate both the annual marginal and the cumulative default probabilities.

Question 5 

Bond A is a three-year $10,000 bond that pays an annual coupon of 6 percent. Bond B is a three-year, $10,000 zero-coupon bond. The bonds are currently trading at par.

1. (2) Which bond is more sensitive to interest rate movements?

2. (6) What is the duration for each of the bonds?

3. (2) What is the dollar duration of Bond A?

4. (6) One year has passed, and rates fall by 1 percent. What are the durations of the two bonds now?

5. (4) Give two reasons why using duration is better than using the maturity gap to manage interest rate risk.

Question 6 

Countries A and B have import ratios of 113 percent and 25 percent, respectively. Their debt service ratios are 30 percent and 15 percent, respectively. (Hint: Import ratio = Total imports/Total foreign exchange reserves; Debt service ratio = Interest plus amortization of debt/Exports.)

1. (3) Based on these ratios, to which country should lenders charge a higher risk premium? Why?

2. (3) What are the shortcomings of only using ratios like these to determine risk?

Question 7 

A bank is planning to make a loan of $7,000,000 to a rm in the car industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 6.5 years. The cost of funds (the RAROC benchmark) for the bank is 12 percent. The bank has estimated the maximum change in the risk premium on the car manufacturing sector to be approximately 4.3 percent, based on two years of historical data. The current market interest rate for loans in this sector is 14 percent.

1. (5) Using the risk-adjusted return on capital (RAROC) model, determine whether the bank should make the loan.

2. (3) What is the highest duration this loan could have and still be approved?

Question 8 

A depository institution (DI) has the following balance sheet (in millions):

Assets Liab. and Equity

Cash 3 Demand deposits 70

Loans 70

Premises 2 Equity 5

Total 75 Total 75

The asset-liability management committee has estimated that the loans, whose average interest rate is 7 percent and whose average life is three years, will have to be discounted at 10 percent if they are to be sold in two days or less. If they can be sold in 4 days, they will have to be discounted at 8 percent. If they can be sold later than a week, the DI will receive the full market value. The principal of the loans is paid at maturity.

1. (4) What will be the price received by the DI for the loans if they have to be sold in two days. In four days?

2. (3) What is the best way for the bank to cover depositors demanding $30 million imme-diately?

Question 9 

Bank Zed has a portfolio of bonds with a market value of $750 million. The bonds have an estimated price volatility of 0.93 percent.

1. (4) What are the DEAR and the 5-day VAR for these bonds?

2. (2) If you know the DEAR of two bond portfolios, why can't you just add the two numbers together to know the DEAR for the entire position?