Question 1 A financial institution has the following market value balance sheet structure: Assets Liabilities and Equity Cash $1,000 Certif of deposit $10,000 Bond $10.000 Equity $1.000 Total assets $11.000 Total liabi& Equ. $11.000 (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? The decrease in net interest income is caused by the increase in financing cost without a corresponding increase in the earnings rate. Thus, the change in NII is caused by refinancing risk. The increase in market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten years. Note: this answer makes no assumption about reinvesting the first year's interest income at the new higher rate. (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 be 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. (5) Cash $1,000 Certificate of deposit $10,000 Bond $9.446 Equity Total assets $10,446 Total liabilities and equity $10,446 (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? (10) 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 be 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. (5) (a) 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? 3) (e) What factors have caused the changes in operating performance and market value for this firm? (5) (f) How does a policy of matching the maturities of assets and liabilities work (@) to minimize interest rate risk and (b) against the asset-transformation function of Fis? (5) (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? (3) The market value of the equity would be higher ($1,600) because the value of the bond would be higher ($10,600) and the value of the CD would remain unchanged. (e) What factors have caused the changes in operating performance and market value for this firm? (5) The operating performance has been affected by changes in market interest rates that have caused corresponding changes in interest income, interest expense, and net interest income. These specific changes have occurred because of the unique matunities of the fixed-rate assets and variable-rate liabilities. Similarly, the economic or market value of the firm has changed because of the effect of the changing rates on the market value of the bond. (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? (f) How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIS? (3) Interest income Interest expense Net interest income (NII) $1,000 600 $400 $10.000 x 0.10 $10,000 x 0.06 (6) 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? A policy of maturity matching will allow changes in market interest rates to have approximately the same effect on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and a decrease in rates will tend to decrease both income and expense. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. The asset- transformation function of an FI involves investing short-term liabilities in long-term assets. Maturity matching clearly works against successful implementation of this process. (10) Interest income Interest expense Net interest income (NII) $1,000 700 $300 $10,000 x 0.10 $10,000 x 0.07 Question 1 A financial institution has the following market value balance sheet structure: Assets Liabilities and Equity Cash $1,000 Certif of deposit $10,000 Bond $10.000 Equity $1.000 Total assets $11.000 Total liabi& Equ. $11.000 (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? The decrease in net interest income is caused by the increase in financing cost without a corresponding increase in the earnings rate. Thus, the change in NII is caused by refinancing risk. The increase in market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten years. Note: this answer makes no assumption about reinvesting the first year's interest income at the new higher rate. (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 be 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. (5) Cash $1,000 Certificate of deposit $10,000 Bond $9.446 Equity Total assets $10,446 Total liabilities and equity $10,446 (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? (10) 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 be 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. (5) (a) 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? 3) (e) What factors have caused the changes in operating performance and market value for this firm? (5) (f) How does a policy of matching the maturities of assets and liabilities work (@) to minimize interest rate risk and (b) against the asset-transformation function of Fis? (5) (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? (3) The market value of the equity would be higher ($1,600) because the value of the bond would be higher ($10,600) and the value of the CD would remain unchanged. (e) What factors have caused the changes in operating performance and market value for this firm? (5) The operating performance has been affected by changes in market interest rates that have caused corresponding changes in interest income, interest expense, and net interest income. These specific changes have occurred because of the unique matunities of the fixed-rate assets and variable-rate liabilities. Similarly, the economic or market value of the firm has changed because of the effect of the changing rates on the market value of the bond. (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? (f) How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIS? (3) Interest income Interest expense Net interest income (NII) $1,000 600 $400 $10.000 x 0.10 $10,000 x 0.06 (6) 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? A policy of maturity matching will allow changes in market interest rates to have approximately the same effect on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and a decrease in rates will tend to decrease both income and expense. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. The asset- transformation function of an FI involves investing short-term liabilities in long-term assets. Maturity matching clearly works against successful implementation of this process. (10) Interest income Interest expense Net interest income (NII) $1,000 700 $300 $10,000 x 0.10 $10,000 x 0.07