QUESTION 1a)

Use this balance sheet information to answer the following questions:

Financial Institution (FI) Balance Sheet (Amount in millions, Duration in years)
Assets	Amount	Duration	Liabilities	Amount	Duration
Cash	50	?	Core Deposits	750	1.25 yrs
Treasury Bonds	350	2.25 yrs	CDs	300	1.00 yrs
Loans (special)	650	?	Euro CDs	?	0.75 yrs
Loans (fixed)	450	3.75 yrs	Equity	150

The bank is considering approving a special loan with the following characteristics:

Loan A: The loan that has 5 years to maturity and has bond-like repayments.

Loan B: The loan has repayments of $123.148 million at the end of year 1, $603.695 million at the end of year 4, and $33.755 million at the end of year 6.

Both loans are trading at par and the yield to maturity is 3.5 percent per annum.

Select the loan that bank should approve. Please provide justification. Assume that both loans have similar default risk.

Assuming a flat yield curve and a parallel shift of the entire yield curve of 50-basis points upward what is the impact on the FI's market value of equity?

QUESTION 1b) Calculate theconvexity for a three-year 3.5% coupon rate with a face value of $500,000 loan with amortised payments?

Use this information to determine the impact on the market value of the amortised loan if the entire yield curve shifted downward 50-basis points.

What is the usefulness of convexity when duration is available as a measure of interest rate risk? What is the practical implication for the three-year loan in this example?