In Round Two of the simulation, you begin to diversify the composition of your assets, choosing among types of loans with varying levels of risk and return. You can also grow your assets further by adding debt with alternative sources of liabilities, including deposits and borrowed funds. Note that different assets and liabilities have different returns and default rates based on the state of the world.

Action Items for Round 2

Part A:

1. Revisit the asset allocation and funding source decisions you made in Round 1 in light of the outcomes (1 through 7) provided by your instructor:

Outcomes	Outcome Probability	Cash	One-Year U.S. Treasury Bills	Five-Year U.S. Treasury Notes	15-Year U.S. Treasury Bonds Notes
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%

• 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

Based on the actual outcome at the end of t=1 and assuming all notes and bonds initially traded at par, that is, the t=0 annual rate is the coupon rate, complete the following table:

Round One Allocation in $ (a)	Annual Rates of Return t=0 (b)	Outcome Rates t=1 (c)	Interest Income t=1 (d)	Asset Valuation t=1 (e)
Cash	0%	0%	0	= a
One-Year U.S. T-Bills	0.16%	= a x b	= a x (1+b)
Five-Year U.S. T-Notes	0.68%	= a x b	See Below
15-Year U.S. T- Bonds	1.66%	= a x b	See Below
Total	$1,000,000			$	$

Assuming coupon payments occur once each year, the values for the initial five-year T-Notes and 15-year T-Bonds at t=1 are calculated as follows:

Five-Year T-Note Value t=1

Fifteen-Year T-Bond Value t=1

Based on the totals above, create a balance sheet at t=1. Assume no dividends, that is, all interest income is retained and that all retained earnings are held as cash.

• Cash at t=1 equals Cash at t=0 plus total interest income for the period.
• Securities at t=1 equal total Asset Valuation of Treasury securities at t=1.
• Common Stock equals Common Stock at t=1.
• Retained Earnings equal interest income in period 1 net of any gains or losses in Treasury securities.

Balance Sheet t=1: End of Round 1
Assets			Liabilities and Shareholders Equity
Cash	Total Liabilities		$0
Securities	Common Stock		$1,000,000
Retained Earnings
Total Shareholders Equity
Total Assets	Total Liabilities and Shareholders Equity

Of course, make sure Total Assets = Total Liabilities and Shareholders' Equity.

2. In a paragraph, discuss what caused the above changes to your bank's balance sheet.

Part B:

1. In Round 2 you are asked to grow your banks balance sheet through the expansion of assets funded by liabilities. Specifically, you can now leverage (increase the liabilities of) your bank up to a multiple of 12x total shareholders equity. Using Balance Sheet t=1: Start of Round 2 make decisions regarding your Round 2 asset allocations and sources of funds. Here are your new alternatives for Round 2:

Assets

• Consumer Loans will earn on average 10% per annum and require a 4% loan loss reserve
• Residential Mortgages will earn on average 5% per annum and require a 2% loan loss reserve
• Commercial and Industrial (C&I) Loans will earn on average 4% per annum and require a 1% loan loss reserve

Liabilities

• Deposits, net of the expenses to attract them, are forecasted to cost 2% per annum
• Borrowed Funds, mainly through the interbank market, are forecasted to cost 1% per annum

Again, we are consolidating all Treasury securities in Round One into a single balance item for Rounds 2-5. All securities going forward will be one-year Treasury bills.

1. To complete Balance Sheet t=2: Start of Round 2 take the following steps:

• First, copy your completed Balance Sheet t=1: End of Round 1 into the balance sheet below. Again, going forward we will assume all investments in "Securities" are held to maturity as one-year Treasury bills.
• Next, decide on the amount of your bank's leverage, that is, how much, either through deposits or borrowed funds, you choose to raise up to 12x the existing shareholder's equity at the end of Round One.
• Then, allocate all of your liabilities and shareholders' equity among the asset alternatives taking into account the following probability of return and cost outcomes in Round 2.

Below are the possible return and cost outcomes in period 2 and their probabilities:

Outcomes	1	2	3	4	5	6	7
Outcome Probability	16.67%	25%	25%	13.89%	13.89%	2.78%	2.78%
Cash	0%	0%	0%	0%	0%	0%	0%
Securities (T-bills)	0.25%	0.25%	0.25%	0.25%	0.25%	0.25%	0.25%
Consumer Loans	Net 6%	Net 7%	Net 5%	Net 8%	Net 4%	Net 8%	Net 2%
Residential Mortgages	Net 2%	Net 3%	Net 1%	Net 4%	Net 0.5%	Net 4%	Net 0%
C&I Loans	Net 3%	Net 4%	Net 2%	Net 5%	Net 1%	Net 5%	Net 0.5%
Deposits	2%	2%	2%	2%	2%	2%	2%
Borrowed Funds	1%	1%	1%	1%	1%	0.50%	3%

• Outcome 1: No Change
• Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated
• Outcome 3: Moderate economic decline: slightly higher loan losses than estimated
• Outcome 4: Strong economic expansion: even fewer loan losses than estimated
• Outcome 5: Strong economic decline: even higher loan losses than estimated
• Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds
• Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

Balance Sheet t=2: Start of Round 2
Assets			Liabilities and Shareholders Equity
Cash	Deposits
Securities (T-Bills)	Borrowed Funds
Consumer Loans*	Total Liabilities
Residential Mortgages*	Common Stock
C&I Loans*	Retained Earnings
Total Shareholders Equity
Total Assets	Total Liabilities and Shareholders Equity

*Loan figures are net of loan loss provisions.

Again, make sure Total Assets = Total Liabilities and Shareholders' Equity

2. In a single type-written page (approximately 250 words, double-spaced) provide the rationale for your Round 2 asset allocation and funding source decisions. Include in your assessment the risks associated with your allocation.

FINA 340 Bank Portfolio Simulation Worksheet Round 2

Version 2.0

Bank Portfolio Round 2

As shown in the FINA 340 course website, you begin to diversify the composition of your assets, choosing among types of loans with varying levels of risk and return. You can also grow your assets further by adding debt with alternative sources of liabilities, including deposits and borrowed funds. Note that different assets and liabilities have different returns and default rates based on the state of the world. Importantly, the responses in this worksheet are what determine your evaluation on the assignment.

Refer to: 1) the instructions in this worksheet, 2) the simulation handbook for previous versions of the exercise provided to you by your instructor (in PDF), and 3) information in the text, Cecchetti, S. G. and Schoenholtz, K (5e). Money, Banking, and Financial Markets.

In Round 2 of the Simulation, you are asked to apply the Outcome, determined by chance, to your banks portfolio. Use the embedded Excel worksheet below. To enter your values, place the cursor onto the table. Next, right click the mouse. Choose Worksheet Object, Edit. You will want to save your work and make sure it appears in the Word document

1. Refer to your Round 1 Bank Balance Sheet. With the Outcome determined by chance, complete the spreadsheet by opening it and using the drop down menu to determine your Banks Outcome from Round

2. In the space below, discuss what caused the changes to your bank's balance sheet during the Round (minimum of 80 words, single spaced, partial credit for less).

In Round 2 you are asked to grow your banks balance sheet through the expansion of assets funded by liabilities. Specifically, you can now leverage (increase the liabilities of) your bank up to a multiple of 12x total shareholders equity.

• Refer to your End of Round 1 Bank Balance Sheet (above). Now add Leverage to your banks Balance Sheet. Use the embedded Excel worksheet below to complete. To enter your values, place the cursor onto the table. Next, right click the mouse. Choose Worksheet Object, Edit. You may use a rounded value in cell C2 to determine your Total Equity at the End of Round 1.
• Allocate your banks Assets in proportion to the Liabilities you added through Leverage.
• Make sure your Balance Sheet totals correctly.

In the space below, provide the rationale (minimum of 90 words, single spaced, partial credit for less) for your Start of Round 2 asset allocation and funding source decisions. Include in your assessment how you might solve the problem of either adverse selection or moral hazard in your allocation (refer to Chapter 11).

4. Refer to Chapter 12, Equation (3), ROE. Assume you wish to attain a return on equity, ROE, of 14% on Shareholders Equity by the end of Round 2. Use the Total Shareholders Equity balance from the Balance Sheet above. How much net profit after tax will your bank need to earn to attain the goal? Show your work below.

Allocation Franklin Week 2 Cash 1yr Syr 15yr Total $ 500,000.00 $ 300,000.00 $ 200,000.00 $ 1,000,000.00 Return 0.000% 0.160% 0.680% 1.660% 0.616% Outcome 2 0.00% $ 0.36% $ 0.88% $ 1.86% $ $ Income Value $ 800.00 $ 500,800.00 2.040.00 $297.651.88 3,320.00 $195.109.44 6.160.00 $ 993.561.33 Cosh Securities Balance Sheet t=1: End of Round 1 Assets Liabilities & Equity S 5,360.00 Total Liabilities $ 993.561.33 Comm Stock S 1,000,000.00 Ret Earnings $ (1.078.67) Total Equity S 998,921.33 Total Assets S 998.921.33 Total L&E S 998,921.33 Make sure your Balance Sheet totals correctly. Start of Round 2 Total Equity End of Round 1 Leverage Lending Available Liabilities Needed 6.00 $ $ Balance Sheet t=2: Start of Round 2 Assets Liabilities & Equity Cash Deposits Securities Borrowed Lending Total Liabilities Cons. Loans $ Residential Mortgage $ Comm Stock C&I* $ Ret Earnings Total Lending Total Equity $ $ Total L&E $ Total Assets * net of loan loss provision Allocation Franklin Week 2 Cash 1yr Syr 15yr Total $ 500,000.00 $ 300,000.00 $ 200,000.00 $ 1,000,000.00 Return 0.000% 0.160% 0.680% 1.660% 0.616% Outcome 2 0.00% $ 0.36% $ 0.88% $ 1.86% $ $ Income Value $ 800.00 $ 500,800.00 2.040.00 $297.651.88 3,320.00 $195.109.44 6.160.00 $ 993.561.33 Cosh Securities Balance Sheet t=1: End of Round 1 Assets Liabilities & Equity S 5,360.00 Total Liabilities $ 993.561.33 Comm Stock S 1,000,000.00 Ret Earnings $ (1.078.67) Total Equity S 998,921.33 Total Assets S 998.921.33 Total L&E S 998,921.33 Make sure your Balance Sheet totals correctly. Start of Round 2 Total Equity End of Round 1 Leverage Lending Available Liabilities Needed 6.00 $ $ Balance Sheet t=2: Start of Round 2 Assets Liabilities & Equity Cash Deposits Securities Borrowed Lending Total Liabilities Cons. Loans $ Residential Mortgage $ Comm Stock C&I* $ Ret Earnings Total Lending Total Equity $ $ Total L&E $ Total Assets * net of loan loss provision