Question
Assume that you have been granted a charter to open a bank with an initial capitalization of $1,000,000. Before you begin to build a loan
Assume that you have been granted a charter to open a bank with an initial capitalization of $1,000,000. Before you begin to build a loan portfolio and take deposits and/or borrow funds, you have the following liquid investment alternatives for your equity funds:
Current Annual Rates of Return, t=0 | |
Cash | 0% |
One-Year U.S. Treasury Bills | 0.16% |
5-Year U.S. Treasury Notes | 0.68% |
15-Year U.S. Treasury Bonds | 1.66% |
In this scenario you face only interest rate risk. There is no credit or default risk and no liquidity risk on U.S. Treasury securities. In order to maximize your profitability you will want to maximize the interest income you earn from your allocation net of any gains or losses in the value of securities due to interest rate changes. In this round and future rounds we are assuming no payments to shareholders, who have provided the initial equity. In this round we are also assuming no liabilities, so there is no interest expense. As a result, your banks profitability in the first round will be its interest income net of any gain or loss to the value of the Treasury securities held.
In these scenarios we will assume 7 possible outcomes with probabilities that approximate a normal distribution and variability up to 3 standard deviations
In Round 1 the possible scenarios of future interest rates at the end of one year and their associated probabilities are follows:
Outcomes | Outcome Probability | Cash | One-Year U.S. Treasury Bills | Five-Year U.S. Treasury Notes | 15-Year U.S. Treasury Bonds |
1 | 16.67% | No Change | No Change | No Change | No Change |
2 | 25 | No Change | 0.36% | 0.88% | 1.86% |
3 | 25 | No Change | 0.06% | 0.58% | 1.56% |
4 | 13.89 | No Change | No Change | 0.78% | 1.86% |
5 | 13.89 | No Change | No Change | 0.58% | 1.46% |
6 | 2.78 | No Change | 0.50% | 0.58% | 0.75% |
7 | 2.78 | No Change | 0.75% | 0.68% | 0.50% |
Please note that any variability in future interest rates involves changes in the U.S. Treasury yield curve as follows:
Outcome 1: No Change
Outcome 2: Upward shift by 20 basis points (bp) in all securities
Outcome 3: Downward shift by 10 bp in all securities
Outcome 4: Upward increase in the slope of the Treasury yield curve
Outcome 5: Decrease in the slope of the Treasury yield curve
Outcome 6: Flattening of the Treasury yield curve
Outcome 7: Inversion of the Treasury yield curve
The outcome will be determined by your instructor and advised to you after Round 1 submissions.
Based on the possible outcomes allocate your initial equity of $1,000,000 among the asset possibilities provided in the initial balance sheet below:
Balance Sheet t=0: Start of Round 1 | |||
Assets | Liabilities and Shareholders Equity | ||
Cash | Liabilities | $0 | |
One-Year U.S. Treasury Bills | Common Stock | $1,000,000 | |
Five-Year U.S. Treasury Notes | Retained Earnings | $0 | |
15-Year U.S. Treasury Bonds | Total Shareholders Equity | $1,000,000 | |
Total Assets | $1,000,000 | Total Liabilities and Shareholders Equity | $1,000,000 |
Of course, make sure Total Assets = Total Liabilities and Shareholders' Equity = $1,000,000
In a single type-written page (approximately 250 words, double-spaced) provide the rationale for your initial allocation of risk capital. Include in your assessment the risks associated with your allocation.
Note* This is mostly opinion based. There just needs to be reasonable logic behind how you allocate assets. Standard variation not necessary at this point.
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