ΑΣΚΗΣΕΙΣ – Κεφάλαιο 2, Ενότητα a

(Κίνδυνος Επιτοκίου)
9.3, 9.4, 9.5, 9.6, 9.7, 9.8, 9.10, 9.11, 9.18, 9.21, 9.24, 9.25, 9.26, 9.27, 9.28, 9.30,
9.32, 9.33, 9.34, 9.35, Integrated Mini Case

9.3 A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12 percent. 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?

ANSWER: CF1/2 = ($100,000 x 0.12 x ½) + $50,000 = $56,000 interest and principal.

CF1 = ($50,000 x 0.12 x 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?

ANSWER: 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 = $100,000.00

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?

ANSWER: X1/2 = $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?

ANSWER: Duration = 0.5283(1/2) + 0.4717(1) = 0.7358

OR

t CF PVof CF PV of CF x t
½ $56,000 $52,830.19 $26,415.09
1 53,000 47,169.81 47,169.81
$100,000.00 $73,584.91
Duration = $73,584.91/$100,000.00 = 0.7358 years

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9.4 Two bonds are available for purchase in the financial markets. The first bond is a two-year,
$1,000 bond that pays an annual coupon of 10 percent. The second bond is a two-year, $1,000,
zero-coupon bond.

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

ANSWER: Coupon Bond: Par value = $1,000 Coupon rate = 10% Annual payments
R = 8% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.9259 $92.59 $92.59
2 1,100 0.8573 943.07 1,886.15
$1,035.67 $1,978.74
Duration = $1,978.74/$1,035.67 = 1.9106

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.9091 $90.91 $90.91
2 1,100 0.8264 909.09 1,818.18
$1,000.00 $1,909.09
Duration = $1,909.09/$1,000.00 = 1.9091

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.8929 $89.29 $89.23
2 1,100 0.7972 876.91 1,753.83
$966.20 $1,843.11
Duration = $1,843.11/$966.20 = 1.9076

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

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

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

ANSWER: Zero Coupon Bond: Par value = $1,000 Coupon rate = 0%

R = 8% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8573 $857.34 $1,714.68
$857.34 $1,714.68
Duration = $1,714.68/$857.34 = 2.0000

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8264 $826.45 $1,652.89
$826.45 $1,652.89
Duration = $1,652.89/$826.45 = 2.0000

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.7972 $797.19 $1,594.39
$797.19 $1,594.39
Duration = $1,594.39/$797.19 = 2.0000

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

ANSWER: 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 than it affects
the zero-coupon bond?

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

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9.5 What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual coupon
selling at par? Selling with a yield to maturity of 12 percent? 14 percent? What can you conclude
about the relationship between duration and yield to maturity? Plot the relationship. Why does this
relationship exist?

ANSWER:
Five-year Treasury Bond: Par value = $1,000, Coupon rate = 10%, Semi-annual payments
R = 10% Maturity = 5 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 50 0.9524 47.620 23.810
1.0 50 0.9070 45.350 45.350
1.5 50 0.8638 43.190 64.785
2.0 50 0.8227 41.135 82.270
2.5 50 0.7835 39.175 97.937
3.0 50 0.7462 37.310 111.930
3.5 50 0.7107 35.535 124.373
4.0 50 0.6768 33.842 135.368
4.5 50 0.6446 32.230 145.035
5.0 1,050 0.6139 644.595 3,222.975
1,000.00 4,053.833
Duration = $4,053.91/$1,000.00 = 4.0539
R = 12% Maturity = 5 years
t CFt
CFt x DFt CFt x DFt x t
0.5 50
47.17 23.58
1.0 50
44.50 44.50
1.5 50
41.98 62.97
2.0 50
39.60 79.21
2.5 50
37.36 93.41
3.0 50
35.25 105.74
3.5 50
33.25 116.38
4.0 50
31.37 125.48
4.5 50
29.59 133.18
5.0 1,050
586.31 2,931.57
926.40 3,716.03
Duration = $3,716.03/$926.40 = 4.0113
Duration and YTM

4,08 4,0539

4,04 4,0113
Years

4,00 3,9676
3,96

3,92
0,10 0,12 0,14

Yield to Maturity
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 R = 14% Maturity = 5 years
t CFt CFt x DFt CFt x DFt x t
0.5 50 46.73 23.36
1.0 50 43.67 43.67
1.5 50 40.81 61.22
2.0 50 38.14 76.29
2.5 50 35.65 89.12
3.0 50 33.32 99.95
3.5 50 31.14 108.98
4.0 50 29.10 116.40
4.5 50 27.20 122.39
5.0 1,050 533.77 2,668.83
859.53 3,410.22
Duration = $3, 410.22/$859.53 = 3.9676

9.6. Consider three Treasury bonds each of which has a 10 percent semi-annual coupon and trades at par.
a. Calculate the duration for a bond that has a maturity of four years, three years, and two years?

ANSWER: Four-year Treasury Bond:

Par value = $1,000, Coupon rate = 10%, Semi-annual payments
R = 10% Maturity = 4 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 50 0.9524 47.62 23.81
1.0 50 0.9070 45.35 45.35
1.5 50 0.8638 43.19 64.79
2.0 50 0.8227 41.14 82.27
2.5 50 0.7835 39.18 97.94
3.0 50 0.7462 37.31 111.93
3.5 50 0.7107 35.53 124.37
4.0 1,050 0.6768 710.68 2,842.72
1,000.00 3,393.19
Duration = $3,393.19/$1,000.00 = 3.3932

R = 10% Maturity = 3 years

t CFt DFt CFt x DFt CFt x DFt x t
0.5 50 0.9524 47.62 23.81
1.0 50 0.9070 45.35 45.35
1.5 50 0.8638 43.19 64.79
2.0 50 0.8227 41.14 82.27
2.5 50 0.7835 39.18 97.94
3.0 1,050 0.7462 783.53 2,350.58
1,000.00 2,664.74
Duration = $2,664.74/$1,000.00 = 2.6647

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 R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 50 0.9524 47.62 23.81
1.0 50 0.9070 45.35 45.35
1.5 50 0.8638 43.19 64.79
2.0 1,050 0.8227 863.84 1,727.68
1,000.00 1,861.62
Duration = $1,861.62/$1,000.00 = 1.8616

b. What conclusions can you reach about the relationship of duration and the time to maturity?
Plot the relationship.

ANSWER: As maturity decreases, duration decreases at a decreasing rate. Although the graph
below does not illustrate with great precision, the change in duration is less than the change
in time to maturity.

Change in Duration and Maturity

Duration Maturity Duration
1.8616 2 4,00
3,3932
2.6647 3 0.8031
3,00
3.3932 4 0.7285 2,6647
Years

2,00
1,8616
1,00

0,00
2 3 4

Time to Maturity

9.7 A six-year, $10,000 CD pays 6 percent interest annually and has a 6 percent yield to maturity.
What is the duration of the CD? What would be the duration if interest were paid semiannually?
What is the relationship of duration to the relative frequency of interest payments?

ANSWER: Six-year CD: Par value = $10,000, Coupon rate = 6%

R = 6% Maturity = 6 years, Annual payments
t CFt DFt CFt x DFt CFt x DFt x t
1 600 0.9434 566.04 566.04
2 600 0.8900 534.00 1,068.00
3 600 0.8396 503.77 1,511.31
4 600 0.7921 475.26 1,901.02
5 600 0.7423 448.35 2,241.77
6 10,600 0.7050 7.472.58 44,835.49
10,000.00 52,123.64
Duration = $52,123.64/$1,000.00 = 5.2124

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 R = 6% Maturity = 6 years Semi-annual payments
t CFt DFt CFt x DFt CFt x DFt x t
0.5 300 0.9709 291.26 145.63
1 300 0.9425 282.78 282.78
1.5 300 0.9151 274.54 411.81
2 300 0.8885 266.55 533.09
2.5 300 0.8626 258.78 646.96
3 300 0.8375 251.25 753.74
3.5 300 0.8131 243.93 853.75
4 300 0.7894 236.82 947.29
4.5 300 0.7664 229.93 1,034.66
5 300 0.7441 223.23 1,116.14
5.5 300 0.7224 216.73 1,192.00
6 10,300 0.7014 7,224.21 43,345.28
10,000.00 51,263.12
Duration = $51,263.12/$10,000.00 = 5.1263
Duration decreases as the frequency of payments increases. This relationship occurs because (a) cash
is being received more quickly, and (b) reinvestment income will occur more quickly from the earlier
cash flows.

9.8. What is a consol bond? What is the duration of a consol bond that sells at a yield to maturity of 8
percent? 10 percent? 12 percent? Would a consol trading at a yield to maturity of 10 percent have a
greater duration than a 20-year zero-coupon bond trading at the same yield to maturity? Why?

ANSWER: A consol bond is a bond that pays a fixed coupon each year forever.
Consol Bond
A consol bond trading at a yield to maturity of 10 percent has a duration R D = 1 + 1/R
of 11 years, while a 20-year zero-coupon bond trading at a ytm 0.08 13.50 years
of 10 percent, or any other ytm, has a duration of 20 years because 0.10 11.00 years
no cash flows occur before the twentieth year. 0.12 9.33 years

9.9 Maximum Pension Fund is attempting to manage one of the bond portfolios under its management.
The fund has identified three bonds which have five year maturities and trade at a yield to maturity of 9
percent. The bonds differ only in that the coupons are 7 percent, 9 percent, and 11 percent.

a. What is the duration for each bond?

ANSWER: Five-year Bond:

Par value = $1,000 Maturity = 5 years Annual payments
R = 9% Coupon rate = 7%
t CFt DFt CFt x DFt CFt x DFt x t
1 70 0.9174 64.22 64.22
2 70 0.8417 58.92 117.84
3 70 0.7722 54.05 162.16
4 70 0.7084 49.59 198.36
5 1,070 0.6499 695.43 3,477.13
922.21 4,019.71
Duration = $4,019.71/$922.21 = 4.3588
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 R = 9%Coupon rate = 9%
t CFt DFt CFt x DFt CFt x DFt x t
1 $90 0.9174 82.57 82.57
2 $90 0.8417 75.75 151.50
3 $90 0.7722 69.50 208.49
4 $90 0.7084 63.76 255.03
5 $1,090 0.6499 708.43 3,542.13
1,000.00 4,239.72
Duration = $4,239.72/$1,000.00 = 4.2397

R = 9%Coupon rate = 11%

t CFt DFt CFt x DFt CFt x DFt x t
1 $110 0.9174 100.92 100.92
2 $110 0.8417 92.58 185.17
3 $110 0.7722 84.94 254.82
4 $110 0.7084 77.93 311.71
5 $1,110 0.6499 721.42 3,607.12
1,077.79 4,459.73
Duration = $4,459.73/$1,077.79 = 4.1378

b. What is the relationship between duration and the amount of coupon interest that is paid?
Plot the relationship.
ANSWER:
Duration decreases as the amount of coupon interest
Duration and Coupon Rates increases.
Change in
Duration Coupon Duration
4,3588 4.3588 7%
Years

4,2397
4,1378
4.2397 9% -0.1191
4.1378 11% -0.1019
4,00
7% 9% 11%

Coupon Rates

9.10 An insurance company is analyzing three bonds and is using duration as the measure of interest
rate risk. All three bonds trade at a yield to maturity of 10 percent, have $10,000 par values, and
have five years to maturity. The bonds differ only in the amount of annual coupon interest that they
pay: 8, 10, and 12 percent.

a. What is the duration for each five-year bond?

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ANSWER:
Five-year Bond: Par value = $10,000, R = 10%, Maturity = 5 years, Annual payments
Coupon rate = 8%
t CFt DFt CFt x DFt CFt x DFt x t
1 800 0.9091 727.27 727.27
2 800 0.8264 661.16 1,322.31
3 800 0.7513 601.06 1,803.16
4 800 0.6830 546.41 2,185.64
5 10,800 0.6209 6,705.95 33,529.75
9,241.84 39,568.14
Duration = $39,568.14/9,241.84 = 4.2814

Coupon rate = 10%

t CFt DFt CFt x DFt CFt x DFt x t
1 $1,000 0.9091 909.09 909.09
2 $1,000 0.8264 826.45 1,652.89
3 $1,000 0.7513 751.31 2,253.94
4 $1,000 0.6830 683.01 2,732.05
5 $11,000 0.6209 6,830.13 34,150.67
10,000.00 41,698.65
Duration = $41.698.65/10,000.00 = 4.1699

Coupon rate = 12%

t CFt DFt CFt x DFt CFt x DFt x t
1 $1,200 0.9091 1,090.91 1,090.91
2 $1,200 0.8264 991.74 1,983.47
3 $1,200 0.7513 901.58 2,704.73
4 $1,200 0.6830 819.62 3,278.46
5 $11,200 0.6209 6,954.32 34,771.59
10,758.16 43,829.17
Duration = $43,829.17/10,758.16 = 4.0740

b) What is the relationship between duration and the amount of coupon interest that is paid?

Duration and Coupon Rates Duration decreases as the amount of coupon

interest increases.
Change in
4,50
Duration Coupon Duration
4,2814
Years

4.2814 8%
4,1699
4,0740 4.1699 10% -0.1115
4,00
4.0740 12% -0.0959
8% 10% 12%

Coupon Rates

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9.11 You can obtain a loan of $100,000 at a rate of 10 percent for two years. You have a choice of
(i) paying the interest (10 percent) each year and the total principal at the end of the second year or
(ii) amortizing the loan, that is, paying interest (10 percent) and principal in equal payments each
year. The loan is priced at par.

a. What is the duration of the loan under both methods of payment?

ANSWER:
(i) Two-year loan: Interest at end of year one; Principal and interest at end of year two
Par value = $100,000, Coupon rate = 10%, Annual Coupon payments
R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $10,000 0.9091 9,090.91 9,090.91
2 $110,000 0.8264 90,909.09 181,818.18
100,000.00 190,909.09
Duration = $190,909.09/$100,000 = 1.9091

(ii) Two-year loan: Amortized over two years

Par value = $100,000 Coupon rate = 10% Annual amortized payments
R = 10% Maturity = 2 years = $57,619.05
t CFt DFt CFt x DFt CFt x DFt x t
1 $57,619.05 0.9091 52,380.95 52,380.95
2 $57,619.05 0.8264 47,619.05 95,238.10
100,000.00 147,619.05
Duration = $147,619.05/$100,000 = 1.4762

b. Explain the difference in the two results

ANSWER: Duration decreases dramatically when a portion of the principal is repaid at the end of
year one. Duration is the weighted-average maturity of an asset. If more weight is given to
early payments, the effective maturity of the asset is reduced.

9.18 Suppose you purchase a six-year, 8 percent coupon bond (paid annually) that is priced to yield
9 percent. The face value of the bond is $1,000.

a. Show that the duration of this bond is equal to five years.

ANSWER:
Six-year Bond: Par value = $1,000 Coupon rate = 8% Annual payments
R = 9% Maturity = 6 years
t CFt DFt CFt x DFt CFt x DFt x t
1 80 0.9174 73.39 73.39
2 80 0.8417 67.33 134.67
3 80 0.7722 61.77 185.32
4 80 0.7084 56.67 226.70
5 80 0.6499 51.99 259.97
6 1,080 0.5963 643.97 3,863.81
955.14 4,743.87
Duration = $4,743.87/955.14 = 4.97  5 years

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 b. Show that if interest rates rise to 10 percent within the next year and your investment horizon is
five years from today, you will still earn a 9 percent yield on your investment.

ANSWER: Value of bond at end of year five: PV = ($80 + $1,000)/1.10 = $981.82

Future value of interest payments at end of year five: $80FVn=4, i=10% = $488.41
Future value of all cash flows at n = 5:
Coupon interest payments over five years $400.00
Interest on interest at 10 percent 88.41
Value of bond at end of year five $981.82
Total future value of investment $1,470.23
Yield on purchase of asset at $955.14 = $1,470.23xPVn=5, i=?%  i = 9.00924%

c. Show that a 9 percent yield also will be earned if interest rates fall next year to 8 percent.
ANSWER: Value of bond at end of year five: PV = ($80 + $1,000)/1.08 = $1,000
Future value of interest payments at end of year five: $80xFVn=5, i=8% = $469.33
Future value of all cash flows at n = 5:
Coupon interest payments over five years $400.00
Interest on interest at 8 percent 69.33
Value of bond at end of year five $1,000.00
Total future value of investment $1,469.33

Yield on purchase of asset at $955.14 = $1,469.33xPVn=5, i=?%  i = 8.99596 percent.

9.21 Two banks are being examined by regulators to determine the interest rate sensitivity of their
balance sheets. Bank A has assets composed solely of a 10-year $1 million loan with a coupon rate
and yield of 12 percent. The loan is financed with a 10-year $1 million CD with a coupon rate and
yield of 10 percent. Bank B has assets composed solely of a 7-year, 12 percent zero-coupon bond
with a current (market) value of $894,006.20 and a maturity (principal) value of $1,976,362.88. The
bond is financed with a 10-year, 8.275 percent coupon $1,000,000 face value CD with a yield to
maturity of 10 percent. The loan and the CDs pay interest annually, with principal due at maturity.

a. If market interest rates increase 1 percent (100 basis points), how do the market values of the
assets and liabilities of each bank change? That is, what will be the net effect on the market value
of the equity for each bank?

ANSWER: For Bank A, an increase of 100 basis points in interest rate will cause the market values
of assets and liabilities to decrease as follows:
Loan: $120,000xPVAn=10,i=13% + $1,000,000xPVn=10,i=13% = $945,737.57
CD: $100,000xPVAn=10,i=11% + $1,000,000xPVn=10,i=11% = $941,107.68

The loan value decreases $54,262.43 and the CD value falls $58,892.32. Therefore, the decrease in
value of the asset is $4,629.89 less than the liability, which is, in turn, the increase in the market
value of equity for Bank A.

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 For Bank B:
Bond: $1,976,362.88xPVn=7,i=13% = $840,074.08
CD: $82,750xPVAn=10,i=11% + $1,000,000xPVn=10,i=11% = $839,518.43
The bond value decreases $53,932.12 and the CD value falls $54,487.79. Therefore, the
decrease in value of the asset is $555.67 less than the liability, which is, in turn, the increase in
the market value of equity for Bank B.

b. What accounts for the differences in the changes in the market value of equity between the two
banks?

ANSWER: The assets and liabilities of Bank A change in value by different amounts because the
durations of the assets and liabilities are not the same, even though the face values and
maturities are the same. For Bank B, the maturities of the assets and liabilities are different, but
the current market values and durations are the same. Thus, the change in interest rates causes
a smaller change in value for both liabilities and assets.

c. Verify your results above by calculating the duration for the assets and liabilities of each bank,
and estimate the changes in value for the expected change in interest rates. Summarize your
results.

ANSWER: Ten-year CD Bank B (values in thousands of $s)

Par value = $1,000 Coupon rate = 8.275% Annual payments
R = 10% Maturity = 10 years
t CFt DFt CFt x DFt CFt x DFt x t
1 82.75 0.9091 75.23 75.23
2 82.75 0.8264 68.39 136.78
3 82.75 0.7513 62.17 186.51
4 82.75 0.6830 56.52 226.08
5 82.75 0.6209 51.38 256.91
6 82.75 0.5645 46.71 280.26
7 82.75 0.5132 42.46 297.25
8 82.75 0.4665 38.60 308.83
9 82.75 0.4241 35.09 315.85
10 1,082.75 0.3855 417.45 4,174.47
894.01 6,258.15
Duration = $6,258.15/894.01 = 7.00
The duration on the CD of Bank B is calculated above to be 7.00 years. Since the bond is a zero-
coupon, the duration is equal to the maturity of 7 years.
Using the duration formula to estimate the change in value:
R 0.01
Bond: Value =  D P   7.00 $894,006.20   $55,875.39
1 R 1.12
R 0.01
CD: Value =  D P   7.00 $894,006.20   $56,891.30
1 R 1.10

The difference in the change in value of the assets and liabilities for Bank B is $1,015.91 using
the duration estimation model. The difference in this estimate and the estimate found in part
(a) above is due to the convexity of the two financial assets.

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 The duration estimates for the loan and CD for Bank A are presented below:
Ten-year Loan Bank A (values in thousands of $s)
Par value = $1,000 Coupon rate = 12% Annual payments
R = 12% Maturity = 10 years
t CFt DFt CFt x DFt CFt x DFt x t
1 120 0.8929 107.14 107.14
2 120 0.7972 95.66 191.33
3 120 0.7118 85.41 256.24
4 120 0.6355 76.26 305.05
5 120 0.5674 68.09 340.46
6 120 0.5066 60.80 364.77
7 120 0.4523 54.28 379.97
8 120 0.4039 48.47 387.73
9 120 0.3606 43.27 389.46
10 1,120 0.3220 360.61 3,606.10
1,000.00 6,328.25
Duration = $6,328.25/$1,000 = 6.3282

Ten-year CD Bank A (values in thousands of $s)

Par value = $1,000 Coupon rate = 10% Annual payments
R = 10% Maturity = 10 years
t CFt DFt CFt x DFt CFt x DFt x t
1 100 0.9091 90.91 90.91
2 100 0.8264 82.64 165.29
3 100 0.7513 75.13 225.39
4 100 0.6830 68.30 273.21
5 100 0.6209 62.09 310.46
6 100 0.5645 56.45 338.68
7 100 0.5132 51.32 359.21
8 100 0.4665 46.65 373.21
9 100 0.4241 42.41 381.69
10 1,100 03855 424.10 4,240.98
1,000.00 6,759.02
Duration = $6,759.02/$1,000 = 6.7590

Using the duration formula to estimate the change in value:

R 0.01
Loan: Value =  D P   6.3282 $1,000,000   $56,501.79
1 R 1.12

R 0.01
CD: Value =  D P   6.7590 $1,000,000   $61,445.45
1 R 1.10

The difference in the change in value of the assets and liabilities for Bank A is $4,943.66 using the
duration estimation model. The difference in this estimate and the estimate found in part (a) above is
due to the convexity of the two financial assets. The reason the change in asset values for Bank A is
considerably larger than for Bank B is because of the difference in the durations of the loan and CD
for Bank A.

13
9.24The balance sheet for Gotbucks Bank, Inc. (GBI), is presented below ($ millions):
Assets Liabilities and Equity
Cash $30 Core deposits $20
Federal funds 20 Federal funds 50
Loans (floating) 105 Euro CDs 130
Loans (fixed) 65 Equity 20
Total assets $220 Total liabilities & equity $220

Notes to the balance sheet: The fed funds rate is 8.5 percent, the floating loan rate is LIBOR + 4 percent,
and currently LIBOR is 11 percent. Fixed rate loans have five-year maturities, are priced at par, and pay
12 percent annual interest. The principal is repaid at maturity. Core deposits are fixed rate for two years
at 8 percent paid annually. The principal is repaid at maturity. Euro CDs currently yield 9 percent.

a. What is the duration of the fixed-rate loan portfolio of Gotbucks Bank?

ANSWER: Five-year Loan (values in millions of $s)

Par value = $65 Coupon rate = 12% Annual payments
R = 12% Maturity = 5 years
t CFt DFt CFt x DFt CFt x DFt x t
1 7.8 0.8929 6.964 6.964
2 7.8 0.7972 6.218 12.436
3 7.8 0.7118 5.552 16.656
4 7.8 0.6355 4.957 19.828
5 72.8 05674 41.309 206.543
65.000 262.427
Duration = $262.427/$65.000 = 4.0373

b. If the duration of the floating-rate loans and fed funds is 0.36 year, what is the duration of GBI’s
assets?

ANSWER: DA = [$30(0) + $20(0.36) + $105(0.36) + $65(4.0373)]/$220 = 1.3974 years

c. What is the duration of the core deposits if they are priced at par?

ANSWER: Two-year Core Deposits (values in millions of $s)

Par value = $20 Coupon rate = 8% Annual payments
R = 8% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 1.6 0.9259 1.481 1.481
2 21.6 0.8573 18.519 37.037
20.000 38.519
Duration = $38.519/$20.000 = 1.9259

14
 d. If the duration of the Euro CDs and fed funds liabilities is 0.401 year, what is the duration of
GBI’s liabilities?

ANSWER: DL = [$20(1.9259) + $50(0.401) + $130(0.401)]/$200 = 0.5535 years

e. What is GBI’s duration gap? What is its interest rate risk exposure?

ANSWER: GBI’s leveraged adjusted duration gap is: 1.3974 - 200/220 x (0.5535) = 0.8942 years
Since GBI’s duration gap is positive, an increase in interest rates will lead to a decrease in the
market value of equity.

f. What is the impact on the market value of equity if the relative change in all interest rates is an
increase of 1 percent (100 basis points)? Note that the relative change in interest rates is
R/(1+R) = 0.01.
ANSWER: For a 1 percent increase, the change in equity value is:
ΔE = -0.8942 x $220,000,000 x (0.01) = -$1,967,280 (new net worth will be $18,032,720).

g. What is the impact on the market value of equity if the relative change in all interest rates is a
decrease of 0.5 percent (-50 basis points)?
ANSWER: For a 0.5 percent decrease, the change in equity value is:
ΔE = -0.8942 x (-0.005) x $220,000,000 = $983,647 (new net worth will be $20,983,647).

h. What variables are available to GBI to immunize the bank? How much would each variable need
to change to get DGAP equal to zero?
ANSWER: Immunization requires the bank to have a leverage adjusted duration gap of 0.
Therefore, GBI could reduce the duration of its assets to 0.5032 (0.5535 x 200/220) years by
using more fed funds and floating rate loans. Or GBI could use a combination of reducing asset
duration and increasing liability duration in such a manner that DGAP is 0.

9.25 Hands Insurance Company issued a $90 million, one-year 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?
ANSWER: The market value of the loan decreases by $2,551,831 to $97,448,169.
MVA = $10,000,000 x PVAn=2, i=11.5% + $100,000,000 x PVn=2, i=11.5% = $97,448,169

The market value of the note decrease $1,232,877 to $88,767,123

MVL = $97,200,000 x PVn=1, i=9.5% = $88,767,123

15
b. What impact did these changes in market value have on the market value of the FI’s equity?

ANSWER: E = A - L = -$2,551,831 – (-$1,232,877) = -$1,318,954

The increase in interest rates caused the asset to decrease in value more than the liability which
caused the market value of equity to decrease by $1,318,954.

c. What was the duration of the loan investment and the liability at the time of issuance?

ANSWER: Two-year Loan (values in millions of $s)

Par value = $100 Coupon rate = 10% Annual payments
R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $10 0.9091 9.091 9.091
2 $110 0.8264 90.909 181.818
100.000 190.909
Duration = $190.909/$100.00 = 1.9091
The duration of the loan investment is 1.9091 years. The duration of the liability is one year
since it is a one year note that pays interest and principal at the end of the year.

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.
ANSWER: The approximate change in the market value of the loan for a 1.5 percent change is:
.015
A  1.9091 * * $100,000,000   $2,603,300. The expected market value of the loan
1.10
using the above formula is $97,396,700.

The approximate change in the market value of the note for a 1.5 percent change is:
0.015
L   1.0 x x $90,000,000   $1,250,000. The expected market value of the note
1.08
using the above formula is $88,750,000.

e. What is the duration gap of Hands Insurance Company after the issuance of the asset and note?
ANSWER: The leverage adjusted duration gap is [1.9091 – (0.9)1.0] = 1.0091 years.

f. What is the change in equity value forecasted by this duration gap for the predicted increase in
interest rates of 1.5 percent?
ANSWER: E = -1.0091x[0.015/(1.10)]x$100,000,000 = -$1,376,045. Note that this calculation
assumes that the change in interest rates is relative to the rate on the loan. Further, this
estimated change in equity value compares with the estimates above in part (d) as follows:
E = A - L = -$2,603,300 - (-$1,250,000) = -$1,353,300.

16
 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?
ANSWER: Obviously, the duration of the loan could be shortened relative to the liability, or the
liability duration could be lengthened relative to the loan, or some combination of both.
Shortening the loan duration would mean the possible use of variable rates, or some earlier
payment of principal. The duration of the liability cannot be lengthened without extending the
maturity life of the note. In either case, the loan officer may have been up against market or
competitive constraints in that the borrower or investor may have had other options. Other
methods to reduce the interest rate risk under conditions of this nature include using derivatives
such as options, futures, and swaps.

9.26 The following balance sheet information is available (amounts in thousands of dollars and
duration in years) for a financial institution:
Amount Duration
T-bills $90 0.50
T-notes 55 0.90
T-bonds 176 x
Loans 2,724 7.00
Deposits 2,092 1.00
Federal funds 238 0.01
Equity 715
Treasury bonds are five-year maturities paying 6 percent semi-annually and selling at par.

a. What is the duration of the T-bond portfolio?

ANSWER:
Five-year Treasury Bond
Par value = $176 Coupon rate = 6% Semi-annual payments
R = 6% Maturity = 5 years

t CFt DFt CFt x DFt CFt x DFt x t

0.5 5.28 0.9709 5.13 2.56
1 5.28 0.9426 4.98 4.98
1.5 5.28 0.9151 4.83 7.25
2 5.28 0.8885 4.69 9.38
2.5 5.28 0.8626 4.55 11.39
3 5.28 0.8375 4.42 13.27
3.5 5.28 0.8131 4.29 15.03
4 5.28 0.7894 4.17 16.67
4.5 5.28 0.7664 4.05 18.21
5 181.28 0.7441 134.89 674.45
176.00 773.18
Duration = $773.18/$176.00 = 4.3931

c. What is the average duration of all the assets?

ANSWER: [(0.5)($90) + (0.9)($55) + (4.3931)($176) + (7)($2,724)]/$3,045 = 6.5470 years

17
 c. What is the average duration of all the liabilities?

ANSWER: [(1)($2,092) + (0.01)($238)]/$2,330 = 0.8989 years

d. What is the leverage adjusted duration gap? What is the interest rate risk exposure?

ANSWER: DGAP = DA - kDL = 6.5470 - ($2,330/$3,045)(0.8989) = 5.8592 years

The duration gap is positive, indicating that an increase in interest rates will lead to a
decrease in the market value of equity.

e. What is the forecasted impact on the market value of equity caused by a relative upward shift in
the entire yield curve of 0.5 percent [i.e., R/(1+R) = 0.0050]?
ANSWER: The market value of the equity will change by:

f. If the yield curve shifts downward by 0.25 percent [i.e., R/(1+R) = -0.0025], what is the
forecasted impact on the market value of equity?
ANSWER: The change in the value of equity is ΔMVE = -5.8592($3,045)(-0.0025) = $44,603. Thus,
the market value of equity will increase by $44,603, to $759,603.

g. What variables are available to the financial institution to immunize the balance sheet? How
much would each variable need to change to get DGAP equal to 0?
ANSWER: Immunization requires the bank to have a leverage adjusted duration gap of 0.
Therefore, the FI could reduce the duration of its assets to 0.6878 years by using more T-bills
and floating rate loans. Or the FI could try to increase the duration of its deposits possibly by
using fixed-rate CDs with a maturity of 3 or 4 years. Finally, the FI could use a combination of
reducing asset duration and increasing liability duration in such a manner that DGAP is 0. This
duration gap of 5.8592 years is quite large and it is not likely that the FI will be able to reduce it
to zero by using only balance sheet adjustments. For example, even if the FI moved all of its
loans into T-bills, the duration of the assets still would exceed the duration of the liabilities after
adjusting for leverage. This adjustment in asset mix would imply foregoing a large yield
advantage from the loan portfolio relative to the T-bill yields in most economic environments.

9.27Assume that a goal of the regulatory agencies of financial institutions is to immunize the ratio of
equity to total assets, that is, (E/A) = 0. Explain how this goal changes the desired duration gap
for the institution. Why does this differ from the duration gap necessary to immunize the total
equity? How would your answers to part (h) in problem 23 and part (g) in problem 25 change if
immunizing equity to total assets was the goal?

ANSWER: In this case, the duration of the assets and liabilities should be equal. Thus, if E = A,
then by definition the leveraged adjusted duration gap is positive, since E would exceed kA by
the amount of (1 – k) and the FI would face the risk of increases in interest rates. In reference to
problems 23 and 25, the adjustments on the asset side of the balance sheet would not need to
be as strong, although the difference likely would not be large if the FI in question is a
depository institution such as a bank or savings institution.

18
9.28 Identify and discuss three criticisms of using the duration gap model to immunize the portfolio of
a financial institution.

ANSWER: The three criticisms are:

a Immunization is a dynamic problem because duration changes over time. Thus, it is necessary to
rebalance the portfolio as the duration of the assets and liabilities change over time.
b Duration matching can be costly because it is not easy to restructure the balance sheet
periodically, especially for large FIs.
c Duration is not an appropriate tool for immunizing portfolios when the expected interest rate
changes are large because of the existence of convexity. Convexity exists because the relation-
ship between security price changes and interest rate changes is not linear, which is assumed in
the estimation of duration. Using convexity to immunize a portfolio will reduce the problem.

9.30 A financial institution has an investment horizon of two years 9.33 months (or 2.777 years).
The institution has converted all assets into a portfolio of 8 percent, $1,000, three-year bonds that
are trading at a yield to maturity of 10 percent. The bonds pay interest annually. The portfolio
manager believes that the assets are immunized against interest rate changes.

a. Is the portfolio immunized at the time of bond purchase? What is the duration of the bonds?
ANSWER: Three-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 3 years
t CFt DFt CFt x DFt CFt x DFt x t
1 80 0.9091 72.73 72.73
2 80 0.8264 66.12 132.23
3 1,080 0.7513 811.42 2,434.26
950.26 2,639.22
Duration = $2,639.22/$950.26 = 2.777
The bonds have a duration of 2.777 years, which is 33.33 months. For practical purposes, the
bond investment horizon is immunized at the time of purchase.

b. Will the portfolio be immunized one year later?

ANSWER: After one year, the investment horizon will be 1 year, 9.33 months (or 1.777 years). At
this time, the bonds will have a duration of 1.9247 years, or 1 year, 11+ months. Thus, the
bonds will no longer be immunized.
Two-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $80 0.9091 72.73 72.73
2 $1,080 0.8264 892.56 1,785.12
965.29 1,857.85
Duration = $1,857.85/$965.29 = 1.9247

19
 c. Assume that one-year, 8 percent zero-coupon bonds are available in one year. What proportion
of the original portfolio should be placed in these bonds to rebalance the portfolio?
ANSWER: The investment horizon is 1 year, 9.33 months, or 21.33 months. Thus, the proportion
of bonds that should be replaced with the zero-coupon bonds can be determined by the
following analysis:
21.33 months = wzero x 12 months + (1 – wzero)x1.9247x12 months  wzero = 15.92 percent
Thus, 15.92 percent of the bond portfolio should be replaced with the zero-coupon bonds after
one year.

9.32. Consider a five-year, 15 percent annual coupon bond with a face value of $1,000. The bond is
trading at a yield to maturity of 12 percent.

a. What is the price of the bond?

ANSWER: PV = $150 x PVAi=12%,n=5 + $1,000 x PVi=12%,n=5 = $1,108.14

b. If the yield to maturity increases 1 percent, what will be the bond’s new price?

ANSWER: PV = $150 x PVAi=13%,n=5 + $1,000 x PVi=13%,n=5 = $1,070.34

c. Using your answers to parts (a) and (b), what is the percentage change in the bond’s price as a
result of the 1 percent increase in interest rates?

ANSWER: P = ($1,070.34 - $1,108.14)/$1,108.14 = -0.0341 or –3.41 percent.

d. Repeat parts (b) and (c) assuming a 1 percent decrease in interest rates.

ANSWER: PV = $150 x PVAi=11%,n=5 + $1,000 x PVi=11%,n=5 = $1,147.84

P = ($1,147.84 - $1,108.14)/$1,108.14 = 0.0358 or 3.58 percent

e. What do the differences in your answers indicate about the rate-price relationships of fixed-rate
assets?

ANSWER: For a given percentage change in interest rates, the absolute value of the increase in
price caused by a decrease in rates is greater than the absolute value of the decrease in price
caused by an increase in rates.

20
9.33. Consider a $1,000 bond with a fixed-rate 10 percent annual coupon rate and a maturity (N) of
10 years. The bond currently is trading at a yield to maturity (YTM) of 10 percent.

a. Based on N, TYM, and coupon rate, complete the rest of the following table, i.e. find the new
Price, the Δprice, and the %ΔPrice:

Coupon New $ Change in Price % Change in Price

N Rate YTM Price from Par from Par

8 10% 9% $1,055.35 $55.35 5.535%

9 10 9 1,059.95 59.95 5.995
10 10 9 1,064.18 64.18 6.418
10 10 10 1,000.00 0.00 0.00
10 10 11 941.11 -58.89 -5.889
11 10 11 937.93 -62.07 -6.207
12 10 11 935.07 -64.93 -6.493

b. Use this information to verify the principles of interest rate-price relationships for fixed-rate
financial assets.

Rule 1. Interest rates and prices of fixed-rate financial assets move inversely.

ANSWER: See the change in price from $1,000 to $941.11 for the change in interest rates
from 10 percent to 11 percent, or from $1,000 to $1,064.18 when rates change from 10
percent to 9 percent.

Rule 2. The longer is the maturity of a fixed-income financial asset, the greater is the change in
price for a given change in interest rates.

ANSWER: change in rates from 10 percent to 11 percent caused the 10-year bond to
decrease in value $58.89, but the 11-year bond decreased in value $62.07, and the 12-
year bond decreased $64.93.

Rule 3. The change in value of longer-term fixed-rate financial assets increases at a decreasing
rate.

ANSWER: For the increase in rates from 10 percent to 11 percent, the difference in the
change in price between the 10-year and 11-year assets is $3.18 ($62.07 - $58.89), while
the difference in the change in price between the 11-year and 12-year assets is $2.86
($64.93 - $62.07).

Rule 4. Although not mentioned in Appendix 9A, for a given percentage () change in interest rates,
the increase in price for a decrease in rates is greater than the decrease in value for an increase in
rates.

ANSWER: For rates decreasing from 10 percent to 9 percent, the 10-year bond increases
$64.18. But for rates increasing from 10 percent to 11 percent, the 10-year bond
decreases $58.89.

21
9.34 MLK Bank has an asset portfolio that consists of $100 million of 30-year, 8 percent coupon,
$1,000 bonds that sell at par.

a. What will be the bonds’ new prices if market yields change immediately by  0.10 percent? What
will be the new prices if market yields change immediately by  2.00 percent?
ANSWER:
At +0.10%: Price = $80 x PVAn=30, i=8.1% + $1,000 x PVn=30, i=8.1% = $988.85
At –0.10%: Price = $80 x PVAn=30, i=7.9% + $1,000 x PVn=30, i=7.9% = $1,011.36

At +2.0%: Price = $80 x PVAn=30, i=10% + $1,000 x PVn=30, i=10% = $811.46

At –2.0%: Price = $80 x PVAn=30, i=6.0% + $1,000 x PVn=30, i=6.0% = $1,275.30

b. The duration of these bonds is 12.1608 years. What are the predicted bond prices in each of the
four cases using the duration rule? What is the amount of error between the duration prediction
and the actual market values?

ANSWER: P = -D x [R/(1+R)] x P

At +0.10%: P = -12.1608 x 0.001/1.08 x $1,000 = -$11.26  P’ = $988.74

At -0.10%: P = -12.1608 x (-0.001/1.08) x $1,000 = $11.26  P’ = $1,011.26

At +2.0%: P = -12.1608 x 0.02/1.08) x $1,000 = -$225.20  P’ = $774.80

At -2.0%: P = -12.1608 x (-0.02/1.08) x $1,000 = $225.20  P’ = $1,225.20

Price - Market Price – based on Amount

Determined Duration Estimation of error
At +0.10%: $ 988.85 $ 988.74 $ 0.11
At -0.10%: $1,011.36 $1,011.26 $ 0.10
At +2.0%: $ 811.46 $ 774.80 $36.66
At -2.0%: $1,275.30 $1,225.20 $50.10

c. Given that convexity is 212.4, what are the bond price predictions in each of the four cases
using the duration plus convexity relationship? What is the amount of error in these
predictions?

ANSWER: P = {-D x [R/(1+R)] + ½ x CX x (R) } x P

2

At +0.10%: P = {-12.1608 x 0.001/1.08 + 0.5 x 212.4 x (0.001)2} x $1,000 = -$11.15

At -0.10%: P = {-12.1608 x (-0.001/1.08) + 0.5 x 212.4 x (-0.001)2} x $1,000 = $11.366

At +2.0%: P = {-12.1608 x 0.02/1.08 + 0.5 x 212.4 x (0.02)2} x $1,000 = -$182.72

At -2.0%: P = {-12.1608 x (-0.02/1.08) + 0.5 x 212.4 x (-0.02)2} x $1,000 = $267.68

22
 Price Price
Price duration & duration &
market convexity convexity Amount
determined estimation estimation of error
At +0.10%: $988.85 -$11.15 $988.85 $0.00
At -0.10%: $1,011.36 $11.37 $1,011.37 $0.01

At +2.0%: $811.46 -$182.72 $817.28 $5.82

At -2.0%: $1,275.30 $267.68 $1,267.68 $7.62

d. Diagram and label clearly the results in parts (a), (b) and (c).

Rate-Price Relationships

$1.400

$1,275.30 Actual Market Price

$1,225.20

Duration Profile

$1.000

The duration and convexity profile is virtually

on the actual market price profile, and thus is $811.46
barely visible in the graph. $774.80

$600
4 6 8 10 12

Percent Yield-to-Maturity

ANSWER: The profiles for the estimates based on only  0.10 percent changes in rates are very
close together and do not show clearly in a graph. However, the profile relationship would be
similar to that shown above for the  2.0 percent changes in market rates.

23
9.35. Estimate the convexity for each of the following three bonds, all of which trade at yield to
maturity of 8 percent and have face values of $1,000.
a) A 7-year, zero-coupon bond.
b) A 7-year, 10 percent annual coupon bond.
c) A 10-year, 10 percent annual coupon bond that has a duration value of 6.994 years
(i.e., approximately 7 years).
Rank the bonds in terms of convexity, and express the convexity relationship between zeros and
coupon bonds in terms of maturity and duration equivalencies.

ANSWER:
Market Value Market Value Capital Loss + Capital Gain
at 8.01 percent at 7.99 percent Divided by Original Price
7-year zero -0.37804819 0.37832833 0.00000048
7-year coupon -0.55606169 0.55643682 0.00000034
10-year coupon -0.73121585 0.73186329 0.00000057
Convexity = 108 x (Capital Loss + Capital Gain) ÷ Original Price at 8.00 percent
7-year zero CX = 100,000,000 x 0.00000048 = 48
7-year coupon CX = 100,000,000 x 0.00000034 = 34
10-year coupon CX = 100,000,000 x 0.00000057 = 57

An alternative method of calculating convexity for these three bonds using the following equation is
illustrated at the end of this problem.
1 n
 CFt 
Convexity 
P x (1  R ) 2
x  
t 1  (1  R )
t
 t  (1  t )

Ranking, from least to most convexity: 7-year coupon bond, 7-year zero, 10-year coupon

Convexity relationships:
Given the same yield-to-maturity, a zero-coupon bond with the same maturity as a coupon bond
will have more convexity. Given the same yield-to-maturity, a zero-coupon bond with the same
duration as a coupon bond will have less convexity.

Zero-coupon Bond
Par value = $1,000 Coupon = 0%
R = 8% Maturity = 7 years
t . CF PV of CF PV of CF x t x(1+t) x(1+R)2
1 0.00 0.00 0.00 0.00
2 0.00 0.00 0.00 0.00
3 0.00 0.00 0.00 0.00
4 0.00 0.00 0.00 0.00
5 0.00 0.00 0.00 0.00
6 0.00 0.00 0.00 0.00
7 1,000.00 583.49 4,084.43 32,675.46
583.49 4,084.43 32,675.46 680.58
Duration = 7.0000
Convexity = 48.011

24
 7-year Coupon Bond
Par value = $1,000 Coupon = 10%
R = 8% Maturity = 7 years
t . CF PVof CF PV of CF x t x(1+t) x(1+R)2
1 100.00 92.59 92.59 185.19
2 100.00 85.73 171.47 514.40
3 100.00 79.38 238.15 952.60
4 100.00 73.50 294.01 1,470.06
5 100.00 68.06 340.29 2,041.75
6 100.00 63.02 378.10 2,646.71
7 1,100.00 641.84 4,492.88 35,943.01
1,104.13 6,007.49 43,753.72 1287.9
Duration = 5.4409
Convexity = 33.974
10-year Coupon Bond
Par value = $1,000 Coupon = 10%
R = 8% Maturity = 10 years
t . CF PV of CF PV of CF x t x(1+t) x(1+R)2
1 100.00 92.59 92.59 185.19
2 100.00 85.73 171.47 514.40
3 100.00 79.38 238.15 952.60
4 100.00 73.50 294.01 1,470.06
5 100.00 68.06 340.29 2,041.75
6 100.00 63.02 378.10 2,646.71
7 100.00 58.35 408.44 3,267.55
8 100.00 54.03 432.22 3,889.94
9 100.00 50.02 450.22 4,502.24
10 1,100.0 509.51 5,095.13 56,046.41
1,134.20 7,900.63 75,516.84 1322.9
Duration = 6.9658
Convexity = 57.083

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 Integrated Mini Case: Calculating and Using Duration GAP

State Bank’s balance sheet is listed below. Market yields and durations (in years) are in parenthesis, and
amounts are in millions.

Assets Liabilities and Equity

Cash $20 Demand deposits $250
Fed funds (5.05%, 0.02) 150 MMDAs (4.5%, 0.50)
T-bills (5.25%, 0.22) 300 (no minimum balance requirement) 360
T-bonds (7.50%, 7.55) 200 CDs (4.3%, 0.48) 715
Consumer loans (6%, 2.50) 900 CDs (6%, 4.45) 1,105
C&I loans (5.8%, 6.58) 475 Fed funds (5%, 0.02) 515
Fixed-rate mortgages (7.85%, 19.50) 1,200 Commercial paper (5.05%, 0.45) 400
Variable-rate mortgages, Subordinated debt:
repriced each quarter (6.3%, 0.25) 580 Fixed-rate (7.25%, 6.65) 200
Premises and equipment 120 Total liabilities $3,545
Equity 400
Total assets $3,945 Total liabilities and equity $3,945

a. What is State Bank’s duration gap?

ANSWER:
DA = [20(0) + 150(0.02) + 300(0.22) + 200(7.55) + 900(2.50) + 475(6.85) + 1,200(19.50) +
580(0.25) + 120(0)]/3,945 = 7.76369 year

DL = [250(0) + 360(0.50) + 715(0.48) + 1,105(4.45) + 515(.02) + 400(.45) + 200(6.65))]/3,545 =

1.96354 years

DGAP = DA - kDL = 7.76369 - ($3,545/$3,945)(1.96354) = 5.99924 years

b. Use these duration values to calculate the expected change in the value of the assets and
liabilities of State Bank for a predicted increase of 1.5 percent in interest rates.
ANSWER:

ΔMVfedfunds = -0.02 x .015/1.0505 x 150m = -$42,837

ΔMVT-bills = -0.22 x .015/1.0525 x 300m = -$940,618
ΔMVT-bonds = -7.55 x .015/1.0750 x 200m = -$21,069,767
ΔMVconsumerloans = -2.50 x 0.015/1.0600 x 900m = -$31,839,623
ΔMVC&Iloans = -6.58 x 0.015/1.0580 x 475m = -$44,312,382
ΔMVfixed-ratemortgages = -19.50 x 0.015/1.0785 x 1,200m = -$325,452,017
ΔMVvariable-ratemortgages = -0.25 x 0.015/1.0630 x 580m = -$2,046,096

=>ΔMVA = -$425,703,339

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 ΔMVMMDAs = -0.50 x 0.015/1.045 x 360m = -$2,583,732
ΔMVCDs = -0.48 x 0.015/1.0430 x 715m = -$4,935,762
ΔMVCDs = -4.45 x 0.015/1.0600 x 1,105m = -$69,583,726
ΔMVfedfunds = -0.02 x 0.015/1.0500 x 515m = -$147,143
ΔMVcommericalpaper = -0.45 x 0.015/1.0505 x 400m = -$2,570,205
ΔMVfixed-ratesubordinatedebt = -6.65 x 0.015/1.0725 x 200m = -$18,601,399

=>ΔMVL = -$98,421,967

c. What is the change in equity value forecasted from the duration values for a predicted increase
in interest rates of 1.5 percent?

ANSWER: ΔMVE = ΔMVA – ΔMVL = -$425,703,339 – (-$98,421,967) = -$327,281,372

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