Consider the simple FI balance sheet below (in millions of dollars).

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Assets Liabilities/Equity

Cash assets $ 1,000 Certificate of deposit $10,000

Bonds 10,000 Equity 1,000

Total Assets $11,000 Liabilities and Equity $11,000

Suppose that depositors unexpectedly withdraw $50 million in deposits and the FI receives no new deposits to replace them. Assume that the FI cannot borrow any more funds in the short-term money markets, and because it cannot wait to get better prices for its assets in the future (as it needs the cash now to meet immediate depositor withdrawals), the FI has to sell any non-liquid assets at 75 cents on the dollar.

A. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year? (Note: Net interest income equals interest income minus interest expense.)

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B. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?

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C. Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will bd the market value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends.

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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 $1,000? Why?