Question 4 A. Assume that you are an official from APRA. In an orientation meeting with bank executives, one of the participants asks you why regulators are more concerned with the capital adequacy of banks compared to the capital holdings of a similar sized non-financial institution. Please briefly respond to this executive. [2 marks] B. Parnell Insurance Company issued a $80 million, one-year, zero-coupon note at 9 percent add-on annual interest (paying one coupon at the end of the year and hence the value of the zero-coupon note at the end of the maturity will be $87.2 million) or with a 9 percent yield. The proceeds were used to fund a $90 million, two-year commercial loan with an 11 percent coupon rate and an 11 percent yield. Immediately after these transactions were simultaneously closed, all market interest rates increased 1.5 percent (150 basis points). Hence, assume AR = 0.015. i. What is the true market value of the loan investment and the liability after the change in interest rates? [1 mark] ii. What impact did these changes in market value have on the market value of Parnell's equity? [1 mark] iii. What was the duration of the loan investment and the liability at the time of issuance? [1 mark] iv. Use these duration values to calculate the expected change in the value of the loan, the liability, and equity for the predicted increase of 1.5 percent in interest rates. [3 marks] V. If the interest rate prediction had been available during the time period in which the loan and the liability were being negotiated, what suggestions would you have offered to reduce the possible effect on the equity of the company? [2 marks] Question 4 A. Assume that you are an official from APRA. In an orientation meeting with bank executives, one of the participants asks you why regulators are more concerned with the capital adequacy of banks compared to the capital holdings of a similar sized non-financial institution. Please briefly respond to this executive. [2 marks] B. Parnell Insurance Company issued a $80 million, one-year, zero-coupon note at 9 percent add-on annual interest (paying one coupon at the end of the year and hence the value of the zero-coupon note at the end of the maturity will be $87.2 million) or with a 9 percent yield. The proceeds were used to fund a $90 million, two-year commercial loan with an 11 percent coupon rate and an 11 percent yield. Immediately after these transactions were simultaneously closed, all market interest rates increased 1.5 percent (150 basis points). Hence, assume AR = 0.015. i. What is the true market value of the loan investment and the liability after the change in interest rates? [1 mark] ii. What impact did these changes in market value have on the market value of Parnell's equity? [1 mark] iii. What was the duration of the loan investment and the liability at the time of issuance? [1 mark] iv. Use these duration values to calculate the expected change in the value of the loan, the liability, and equity for the predicted increase of 1.5 percent in interest rates. [3 marks] V. If the interest rate prediction had been available during the time period in which the loan and the liability were being negotiated, what suggestions would you have offered to reduce the possible effect on the equity of the company? [2 marks]
