Question 5 A. Shaun 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 Shaun's equity? [2 marks] 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? [1 mark] B. Briefly explain why it is difficult for small banks, credit unions and building societies to measure credit risk using modern portfolio theory. [2 marks] Question 5 A. Shaun 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 Shaun's equity? [2 marks] 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? [1 mark] B. Briefly explain why it is difficult for small banks, credit unions and building societies to measure credit risk using modern portfolio theory. [2 marks]
