Week 2 Practice questions solution

Chapter 3 End-Chapter questions

Q4. Contrast the balance sheet of DIs with that of a typical life insurance company,
a money market company and a managed fund.

The majority of depository institutions’ liabilities are short term, while the majority
of a life insurance company’s liabilities are long term. Banks have both short-term
and long-term assets but need to hold short-term assets to meet liquidity needs.
Insurance companies match their long-term liabilities with an emphasis on longer
term assets. Historically, both groups used their funds to finance an asset portfolio
made up of debt securities, but insurance companies have been increasing their
holdings in equity at the expense of debt since the 1960s. Banks generally do not
hold equity securities in large proportions. A similarity between the two groups is in
the high degree of financial leverage. Life insurance companies access sources of
funds (from policyholders) in much the same way as depository institutions obtain
deposits. Money market corporations’ liabilities tend to be more like those of
banks—relatively short term. However, the assets of money market corporations
also tend to be short term in nature. Unit trusts, on the other hand, have longer term
asset and liability structures.

Chapter 5 End-Chapter questions

Q4. What is a maturity bucket in the repricing model? Why is the length of time
selected for repricing assets and liabilities important when using the repricing
model?

The maturity bucket is the time window over which the dollar amounts of assets and
liabilities are measured. The length of the repricing period determines which of the
securities in a portfolio are rate sensitive. The longer the repricing period, the more
securities either mature or will be repriced, and, therefore, the more the interest
rate risk exposure. An excessively short repricing period omits consideration of the
interest rate risk exposure of assets and liabilities that are repriced in the period
immediately following the end of the repricing period. That is, it understates the rate
sensitivity of the balance sheet. An excessively long repricing period includes many
securities that are repriced at different times within the repricing period, thereby
overstating the rate sensitivity of the balance sheet.

Q6. Calculate the repricing gap and impact on net interest income of a 1 per cent
increase in interest rates for the following positions:
(a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million.

Repricing gap = RSA – RSL = $100 – $50 million = +$50 million.

NII = ($50 million)(0.01) = +$0.5 million

(b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million.

Repricing gap = RSA – RSL = $50 – $150 million = –$100 million

NII = (–$100 million)(0.01) = –$1 million

(c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million

Repricing gap = RSA – RSL = $75 – $70 million = +$5 million

NII = ($5 million)(0.01) = $0.05 million

(d) Compare the interest rate risk exposure of the institutions in parts (a), (b) and (c).

The FIs in parts (a) and (c) are exposed to interest rate declines (positive repricing
gap) while the FI in part (b) is exposed to interest rate increases. However, the FI in
(a) has greater exposure than the FI in part (b). The FI in part (c) has the least (most)
amount of interest rate risk exposure since the absolute value of the repricing gap is
the lowest (highest).

Q8. Which of the following is an appropriate change to make on a bank’s balance

sheet when GAP is negative, spread is expected to remain unchanged and interest
rates are expected to rise?

According to the CGAP effect, when CGAP is positive the change in NII is positively
related to the change in interest rates. Thus, an FI would want its CGAP to be
positive when interest rates are expected to rise.

(a) Replace fixed-rate loans with rate-sensitive loans.

Yes. This change will increase RSAs, which will increase GAP.

(b) Replace marketable securities with fixed-rate loans.

No. This change will decrease RSAs, which will decrease GAP.

(c) Replace fixed-rate CDs with rate-sensitive CDs.

No. This change will increase RSLs, which will decrease GAP.
(d) Replace equity with demand deposits.

No. This change will have no impact on either RSAs or RSLs. So, no impact on GAP
either.

(e) Replace vault cash with marketable securities.

Yes. This change will increase RSAs, which will increase GAP.

Q9. If a bank manager was quite certain that interest rates were going to rise within
the next six months, how should the bank manager adjust the bank’s six-month
repricing gap to take advantage of this anticipated rise? What if the manger believed
rates would fall in the next six months?

When interest rates are expected to rise, a bank should set its repricing gap to a
positive position. In this case, as rates rise, interest income will rise by more than
interest expense. The result is an increase in net interest income. When interest
rates are expected to fall, a bank should set its repricing gap to a negative position.
In this case, as rates fall, interest income will fall by less than interest expense. The
result is an increase in net interest income.

Q11. What are the reasons for not including savings account demand deposits as
rate-sensitive liabilities in the repricing analysis for a commercial bank? What is the
subtle but potentially strong reason for including savings account demand deposits
in the total of rate-sensitive liabilities? Can the same argument be made for other
on-demand deposit accounts?

The earnings rate available on savings deposit accounts is very low with interest
often paid only on higher balances. Although some banks offer accounts on which
interest can be paid on total balances, this interest rate seldom is changed and thus
the accounts are not really interest rate sensitive. Whether or not interest is paid on
such deposits, savings accounts do pay implicit interest in the form of not charging
fully for cheque, ATM, EFTPOS and other services. Further, when market interest
rates rise, customers draw down their deposit accounts, which may cause the bank
to use higher cost sources of funds. The same or similar arguments can be made for
all on-demand deposit accounts.
Integrated mini case: Calculating and using the repricing GAP

Allied National Bank’s balance sheet is listed below. Market yields are in parenthesis, and
amounts are in millions.

Assets Million Liabilities and equity Million

Cash 20 Demand deposits 250
Interbank lending (5.05%) 150 Savings accounts (1.5%) 20
3-month T-notes (5.25%) 150 Money market deposit accounts 340
(4.5%) (no minimum balance
requirement)
2-year T-Bonds (6.50%) 100 3-month CDs (4.2%) 120
8-year T-Bonds (7.50%) 200 6-month CDs (4.3%) 220
5-year corporate bonds (floating 50 1-year CDs (4.5%) 375
rate) (8.20%, repriced @ 6
months)
6-month consumer loans (6%) 250 2-year CDs (5%) 425
1-year consumer loans (5.8%) 300 4-year CDs (5.5%) 330
5-year personal loans (7%) 350 5-year CDs (6%) 350
7-month commercial loans (5.8%) 200 Interbank borrowings (5%) 225
2-year commercial loans (floating 275 Overnight repos (5%) 290
rate) (5.15%, repriced @ 6-
months)
15-year variable rate mortgages 200 6-month bank accepted bills 300
(5.8%, repriced @ 6-months) (5.05%)
15-year variable rate mortgages 400 Subordinate notes: 3-year fixed 200
(6.1%, repriced @ year) rate (6.55%)
15-year fixed-rate mortgages 300 Subordinated debt: 7-year fixed 100
(7.85%) rate (7.25%)
30-year variable rate mortgages 225 Total liabilities 3545
(6.3%, repriced @ quarter)
30-year variable rate mortgages 355
(6.4%, repriced @ month)
30-year fixed-rate mortgages 400
(8.2%)
Premises and equipment 20 Equity 400
Total assets $3945 Total liabilities and equity $3945

(a) What is the repricing gap if the planning period is 30 days? 6 months? 1 year? 2 years?
5 years?
 Assets Repricing period
Cash $20 Not rate sensitive
Interbank Lending (5.05%) 150 30 days
3-month T-notes (5.25%) 150 6-months
2-year T-bonds (6.50%) 100 2 years
8-year T-bonds (7.50%) 200 Not rate sensitive
5-year corporate bonds (floating
rate) (8.20%, repriced @ 6
months) 50 6 months
6-month consumer loans (6%) 250 6 months
1-year consumer loans (5.8%) 300 1 year
5-year personal loans (7%) 350 5 years
7-month commercial loans (5.8%) 200 1 year
2-year commercial loans (floating
rate) (5.15%, repriced @ 6-
months) 275 6 months
15-year variable rate mortgages
(5.8%, repriced @ 6-months) 200 6 months
15-year variable rate mortgages
(6.1%, repriced @ year) 400 1 year
15-year fixed-rate mortgages
(7.85%) 300 Not rate sensitive
30-year variable rate mortgages
(6.3%, repriced @ quarter) 225 6 months
30-year variable rate mortgages
(6.4%, repriced @ month) 355 30 days
30-year fixed-rate mortgages
(8.2%) 400 Not rate sensitive
Premises and equipment 20 Not rate sensitive

Liabilities and equity Repricing period

Demand deposits $250 Not rate sensitive
Savings accounts (1.5%) 20 30 days
Money market deposits (4.5%)
(no minimum balance
requirement) 340 30 days
3-month CDs (4.2%) 120 6 months
6-month CDs (4.3%) 220 6 months
1-year CDs (4.5%) 375 1 year
2-year CDs (5%) 425 2 years
4-year CDs (5.5%) 330 5 years
5-year CDs (6%) 350 5 years
Fed funds (5%) 225 30 days
Overnight repos (5%) 290 30 days
6-month commercial paper
(5.05%) 300 6 months
Subordinate notes: 3-year fixed
rate (6.55%) 200 5 years
Subordinated debt: 7-year fixed
rate (7.25%) 100 Not rate sensitive
Equity 400 Not rate sensitive

30-day repricing gap: RSAs = $150m + $355m = $505m

RSLs = $20m + $340m + $225m + $290m = $875m
 CGAP = $505m – $875m = –$370m
6-month repricing gap: RSAs = $505m + $150m + $50m + $250m + $275m + $200m
+ $225m = $1655m
RSLs = $875m + $120m + $220m + $300m = $1515m
CGAP = $1655m – $1515m = $140m
1-year repricing gap: RSAs = $1655m + $300m + $200m + $400m = $2555m
RSLs = $1515m + $375m = $1890m
CGAP = $2555m – $1890m = $665m
2-year repricing gap: RSAs = $2555m + $100m = $2655m
RSLs = $1890m + $425m = $2315m
CGAP = $2655m – $2315m = $340m
5-year repricing gap: RSAs = $2655m + $350m = $3005m
RSLs = $2315m + $330m + $350m + $200m = $3195m
CGAP = $3005m – $3195m = –$190m

(b) What is the impact over the next six months on net interest income if interest rates on
RSAs increase 60 basis points and on RSLs increase 40 basis points?

ΔNII (6 months) = ΔII (6 months) – ΔIE (6 months) = $1655m(.0060) – $1515m(.0040) =

$3.87m

(c) What is the impact over the next year on net interest income if interest rates on RSAs
increase 60 basis points and on RSLs increase 40 basis points?

ΔNII (1 year) = ΔII (1 year) – ΔIE (1 year) = $2555m(.0060) – $1890m(.0040) = $7.77m

Chapter 6 End-Chapter questions

Q3. A one-year, $100 000 loan carries a coupon rate and a market interest rate of 12 per cent.
The loan requires payment of accrued interest and one-half of the principal at the end of six
months. The remaining principal and accrued interest are due at the end of the year.

(a) What will be the cash flows at the end of six months and at the end of the year?

CF1/2 = ($100 000 × 0.12 × ½) + $50 000 = $56 000 interest and principal
CF1 = ($50 000 × 0.12 × ½) + $50 000 = $53 000 interest and principal

(b) What is the present value of each cash flow discounted at the market rate? What is the total
present value?

PV of CF1/2 = $56 000  1.06 = $52 830.19

PV of CF1 = $53 000  (1.06)2 = $47 169.81

PV Total CF = $100 000

(c) What proportion of the total present value of cash flows occurs at the end of six months?
What proportion occurs at the end of the year?

X½ = $52 830.19  $100 000 = 0.5283 = 52.83%

X1 = $47 169.81  $100 000 = 0.4717 = 47.17%

(d) What is the duration of this loan?

Duration = 0.5283 * 0.5 + 0.4717 * 1 = 0.7358 years

Q4. Two bonds are available for purchase in the financial markets. The first bond is a two-year,
$1000 bond that pays an annual coupon of 10 per cent. The second bond is a two-year, $1000,
zero-coupon bond.

(a) What is the duration of the coupon bond if the current yield-to-maturity (R) is 8 per cent? 10
per cent? 12 per cent? (Hint: You may wish to create a spread sheet program to assist in the
calculations.)

Coupon bond: Par value = $1000 Coupon rate = 10% Annual payments

R = 8% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $92.59 $92.59
1 $1100 $943.07 $1886.15
$1035.67 $1978.74

Duration = $1978.74/$1035.67 = 1.9106

R = 10% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $90.91 $90.91
1 $1100 $909.09 $1818.18
$1000.00 $1909.09

Duration = $1909.09/$1000.00 = 1.9091

R = 12% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $89.29 $89.23
1 $1100 $876.91 $1753.83
$966.20 $1843.11

Duration = $1843.11/$966.20 = 1.9076

(b) How does the change in the current yield to maturity affect the duration of this coupon
bond?

Increasing the yield to maturity decreases the duration of the bond.

(c) Calculate the duration of the zero-coupon bond with a yield to maturity of 8 per cent, 10 per
cent and 12 per cent.

Zero-coupon bond: Par value = $1000 Coupon rate = 0%

R = 8% Maturity = 2 years

t CF PV of CF PV of CF × t
2 $1000 $857.34 $1714.68
$857.34 $1714.68

Duration = $1714.68/$857.34 = 2.0000

R = 10% Maturity = 2 years

t CF PV of CF PV of CF × t
2 $1000 $826.45 $1652.89
$826.45 $1652.89

Duration = $1652.89/$826.45 = 2.0000

R = 12% Maturity = 2 years

t CF PV of CF PV of CF × t
2 $1000 $797.19 $1594.39
$797.19 $1594.39

Duration = $1594.39/$797.19 = 2.0000

(d) How does the change in the yield to maturity affect the duration of the zero-coupon bond?

Changing the yield to maturity does not affect the duration of the zero-coupon bond.

(e) Why does the change in the yield to maturity affect the coupon bond differently to the way
it affects the zero-coupon bond?

Increasing the yield to maturity on the coupon bond allows for a higher reinvestment income
that more quickly recovers the initial investment. The zero-coupon bond has no cash flow until
maturity.