QUESTION 1(a)

SBSC bank currently pays 1.75% p.a. on 12-month term deposits and expects to be able to attract similar funds in 12 months time at a cost of 1.5%. Accordingly, it has priced a fixed two-year loan of $4,500,000 at 1.0% over the expected cost of funds with interest paid annually. The day following the issue of the loan, the yield on both one- year and two-year maturity government bonds (indicators of market rates) decreased by 0.25% p.a.

1. Ignoring all other assets and liabilities calculate the present value of the expected interest margin.

QUESTION 1(b)

CONBANK bank has the following market value balance sheet structure:

Assets		Liabilities and Equity
Cash	$2,000	Certificate of Deposit	$20,000
Bond	$20,000	Equity	$2,000
Total	$22,000		$22,000

The bond has a 20-year maturity and fixed-coupon rate of 5 percent. The certificate of deposit has a one-year maturity and a 3 percent fixed rate of interest. SBSC bank expects no additional asset growth.

1. If at the end of the year one market interest rate decreased by 50 basis points, what will be the net interest income for the second year?

2. (ii) Calculate the market value of equity at the end of year one assuming that market interest rates decreased by 50 basis points.

QUESTION 1(c) [ 5 marks]

Applicants for single period loans of $1,500,000 at the contracted interest rate of 3.0% per annum (p.a.) have been assessed to a range of default probabilities. The bank can finance these loans at the risk-free rate of 1.25% p.a. What is the cut-off default probability? What implication does this result have for the banks screening function?