A financial institution has the following balance sheet structure:

The USD 100 million bond has a three year maturity paying 10 percent interest per year. The USD 100 million certificate of deposit has a two-year maturity and paying 8 percent interest per year. The bond and certificate of deposit will be rolled over after their maturities at the respective prevailing market rates. The financial institution expects no additional asset growth.

a) What will be the financial institutions net interest income (NII) over the five-year investment horizon if the interest rate decreases by 1 percent per annum after the first year and decreases by 1 percent per annum after the third year?

b) What will be the financial institutions net interest income (NII) over five-year investment horizon if the interest rate increases by 1 percent per annum after the second year and increases by 1 percent per annum after the fourth year?

c) Assuming that market interest rates increase by 1 per cent, the bond will have a value of USD99.9 million at the end of year one. What will be the market value of the equity for the financial institution? Assume that all of the NII in part a) is used to cover operating expenses or is distributed as dividends.

d) If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than USD30 million? Why?

Assets USD million Liabilities USD million Cash 10 Equity 30 Bond 100 Certificate of Deposit 100 Real Estate 20 Total 130 Total 130