Question 1

Consider the following two banks:

Bank X has assets composed solely of a 10-year, 12 percent coupon, $1 million loan with a 12 percent yield to maturity. It is financed with a 10-year, 10 percent coupon, $1 million CD with a 10 percent yield to maturity.

Bank Y has assets composed solely of a 7-year, 12 percent, zero-coupon bond with current value of $894,006.20 and a maturity value of $1,976,362.88. It is financed by a 10-year, 8.275 percent coupon, $1,000,000 face value CD with a yield to maturity of 10 percent.

All securities expect the zero-coupon bond pay interest annually.

a.If interest rates rise by 1 percent (100 basis points), how do the values of the assets and liabilities of each bank change? [10 marks]

b.What accounts for the differences between the two banks' accounts? [5 marks]