Question Three:

1. If you are working with the asset-liability committee in one of the big banks and the committee knew that the interest rates will increase within the next six months. How can banks take advantage of this opportunity?

1. What will you do if the repricing gap is positive or negative?

2. Would it be possible to adjust the repricing Gap in a 6-month time?

3. In light of what you have learned about interest rate risk, what else can you do to deal with this situation?

3. marks)

2. The liquidity problems in managed funds are different from those faced by commercial banks and insurance companies?

1. Discuss the above statement briefly and explain how does the liquidity risk of an open-end managed fund compare with that of a closed-end fund?

2. Discuss briefly why deposit insurance can decrease bank run and how can this scheme lead to a moral hazard problem.

3. What is meant by value at risk (VAR)? How is VAR related to DEAR in the RiskMetrics Model?

(3 marks)

3. East Point Bank has outstanding of a $5 000 000 face value, adjustable rate loan to a company that has a leverage ratio of 80 per cent. The current risk-free interest rate is 6 per cent, and the time to maturity on the loan is exactly year. The asset risk of the borrower, as measured by the standard deviation of the rate of change in the value of the underlying assets, is 12 per cent. The normal density function values are given below: ( Assume N(h1) = 0.003778 & N(h2) = 0.995123)

Use the Merton option valuation model to determine:

1. Calculate h1 and h2
2. The market value of the loan
3. The loan rate