1. Consider the following balance sheet for WatchoverU Savings, Inc.

(in millions):

Assets Liabilities and Equity

Floating-rate mortgages 1-year time deposits
(currently 10% annually) $50 (currently 6% annually) $70
30-year fixed-rate loans 3-year time deposits
(currently 7% annually) $50 (currently 7% annually) $20
Equity $10
Total assets $100 Total liabilities & equity $100

a. What is WatchoverU’s expected net interest income for the year?

Current expected interest income: $50m(0.10) + $50m(0.07) = $8.5m.

Expected interest expense: $70m(0.06) + $20m(0.07) = $5.6m.
Expected net interest income: $8.5m - $5.6m = $2.9m.

b. What will expected net interest income be if interest rates rise today by 2
percent?

After the 2 percent interest rate increase, net interest income is:
50(0.12) + 50(0.07) - 70(0.08) - 20(.07) = $9.5m - $7.0m = $2.5m, a decline of
$0.4m.

c. Using the cumulative repricing gap model, what is the expected net interest
income for a 2 percent increase in interest rates?

WatchoverU’s repricing or funding gap is $50m - $70m = -$20m. The change in net
interest income using the funding gap model is (-$20m)(0.02) = -$0.4m.

d. What will expected net interest income over the next year if interest rates on
RSAs increase by 2 percent but interest rates on RSLs increase by 1 percent?
Is it reasonable for changes in interest rates on RSAs and RSLs to differ?
Why?

After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) –
70(0.07) – 20(0.07) = $9.5m - $6.3m = $3.2m, an increase of $0.3m. It is not
uncommon for interest rates to adjust in an unequal manner on RSAs versus RSLs.
Interest rates often do not adjust solely because of market pressures. In many cases,
the changes are affected by decisions of management. Thus, you can see the
difference between this answer and the answer for part a.
2. Use the following information about a hypothetical government security dealer
named M. P. Jorgan. Market yields are in parenthesis, and amounts are in
millions.

Assets Liabilities and Equity

Cash $10 Overnight repos $170
1-month T-bills (7.05%) 75 Subordinated debt
3-month T-bills (7.25%) 75 7-year fixed rate (8.55%) 150
2-year business loans (7.50%) 50
8-year mortgage loans (8.96%) 100
5-year munis (floating rate)
(8.20% reset every 6 months) 25 Equity 15
Total assets $335 Total liabilities & equity $335

a. What is the repricing gap if the planning period is 30 days? 3 months? 2

years? Recall that cash is a non-interest-earning asset.

Repricing gap using a 30-day planning period = $75m - $170m = -$95 million.
Repricing gap using a 3-month planning period = ($75m + $75m) - $170m = -$20
million.
Reprising gap using a 2-year planning period = ($75m + $75m + $50m + $25m) -
$170m = +$55 million.

b. What is the impact over the next 30 days on net interest income if interest
rates increase 50 basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will decrease by
$475,000.
NII = CGAP(R) = -$95m(0.005) = -$0.475m.

If interest rates decrease by 75 basis points, net interest income will increase by
$712,500. NII = CGAP(R) = -$95m(-0.0075) = $0.7125m.

c. The following one-year runoffs are expected: $10 million for two-year
business loans and $20 million for eight-year mortgage loans. What is the
one-year repricing gap?

The repricing gap over the 1-year planning period = ($75m. + $75m. + $10m. +
$20m. + $25m.) - $170m. = +$35 million.

d. If runoffs are considered, what is the effect on net interest income at year-
end if interest rates increase 50 basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will increase by
$175,000. NII = CGAP(R) = $35m(0.005) = $0.175m.

If interest rates decrease 75 basis points, net interest income will decrease by
$262,500. NII = CGAP(R) = $35m(-0.0075) = -$0.2625m.
3. The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semiannual
coupon and selling at par has been estimated at 6.9106 years.

a. What is the modified duration of the bond? What is the dollar duration of
the bond?

Modified duration = D/(1 + R/2) = 6.9106/(1 + 0.10/2) = 6.582 years

Dollar duration = MD x P = 6.582 x $1,000 = 6582

b. What will be the estimated price change on the bond if interest rates
increase 0.10 percent (10 basis points)? If rates decrease 0.20 percent
(20 basis points)?

For an interest rate increase of 0.10 percent:

Estimated change in price = - dollar duration x R = -6582 x 0.001 = -
$6.582
=> new price = $1,000 - $6.582 = $993.418
For an interest rate decrease of 0.20 percent:
Estimated change in price = -6582 x -0.002 = $13.163
=> new price = $1,000 + $13.163 = $1,013.163

c. What would the actual price of the bond be under each rate change
situation in part (b) using the traditional present value bond pricing
techniques? What is the amount of error in each case?

Rate Price Actual

Change Estimated Price Error
+ 0.001 $993.418 $993.448 $0.030
- 0.002 $1,013.163 $1,013.284 -$0.121

4. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent

semiannual coupon Treasury bond selling at par. The duration of this bond has
been estimated at 9.94 years. The assets are financed with equity and a $900,000,
two-year, 7.25 percent semiannual coupon capital note selling at par.
a. What is the leverage adjusted duration gap of Financial Institution XY?

The duration of the capital note is 1.8975 years.

Two-year Capital Note (values in thousands of $s)

Par value = $900 Coupon rate = 7.25% Semiannual payments
R = 7.25% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 32.625 0.9650 31.48 15.74
1 32.625 0.9313 30.38 30.38
1.5 32.625 0.8987 29.32 43.98
2 932.625 0.8672 808.81 1,617.63
900.00 1,707.73
Duration = $1,707.73/$900.00 = 1.8975
 The leverage-adjusted duration gap can be found as follows:
$ 900,000
Leverage−adjusted duration gap = [ D A − D L k ]= 9.94 − 1.8975 = 8.23 225 years
$1,000,000
b. What is the impact on equity value if the relative change in all market
interest rates is a decrease of 20 basis points? Note: The relative change
in interest rates is R/(1+R/2) = -0.0020.

The change in net worth using leverage adjusted duration gap is given by:

ΔR 9
ΔE = −[ D A − D L k ]∗A∗
1+
R [
= − 9 . 94−(1. 8975 )⟨
10 ]
⟩ (1 , 000 ,000 )(−0 .0020 ) = $ 16 , 464
2
c. Using the information calculated in parts (a) and (b), what can be said about
the desired duration gap for the financial institution if interest rates are
expected to increase or decrease.

If the FI wishes to be immune from the effects of interest rate risk (either
positive or negative changes in interest rates), a desirable leverage-adjusted
duration gap (DGAP) is zero. If the FI is confident that interest rates will fall, a
positive DGAP will provide the greatest benefit. If the FI is confident that rates
will increase, then negative DGAP would be beneficial.

d. Verify your answer to part (c) by calculating the change in the market
value of equity assuming that the relative change in all market interest
rates is an increase of 30 basis points.
ΔR
ΔE = −[ D A − D L k ]∗A∗ = − [ 8 . 23225 ] (1 ,000 , 000 )(0.003 ) = −$ 24 , 697
R
1+
2
e. What would the duration of the assets need to be to immunize the
equity from changes in market interest rates?

Immunizing the equity from changes in interest rates requires that the DGAP be
0. Thus, (DA-DLk) = 0  DA = DLk, or DA = 1.8975x0.9 = 1.70775 years.

5. If the rate on one-year Treasury strips currently is 6 percent, what is the

repayment probability for each of the following two securities? Assume that if the
loan is defaulted, no payments are expected. What is the market-determined risk
premium for the corresponding probability of default for each security?

a. One-year AA-rated zero coupon bond yielding 9.5 percent.

Probability of repayment = p = (1 + i)/(1 + k)

For an AA-rated bond = (1 + 0.06)/ (1 + 0.095) = 0.9680, or 96.80 percent
 => probability of default = 1 – 0.9680 = 0.0320, or 3.20%

The market determined risk premium is 0.095 – 0.060 = 0.035 or 3.5 percent. This
implies a probability of default of 3.2 percent on an AA-rated corporate bond requires
an FI to set a risk premium of 3.5 percent.

b. One-year BB-rated zero coupon bond yielding 13.5 percent.

Probability of repayment = p = (1 + i)/(1 + k)

For BB-rated bond = (1 + 0.06)/(1 + 0.135) = 93.39 percent
=> probability of default = 1 – 0.9339 = 0.0661, or 6.61%

The market determined risk premium is 0.135 – 0.060 = 0.075 or 7.50 percent. This
implies a probability of default of 6.61 percent on a BB-rated corporate bond requires
an FI to set a risk premium of 7.5 percent.

6. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It

expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8
years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for
the bank is 10 percent. The bank has estimated the maximum change in the risk
premium on the steel manufacturing sector to be approximately 4.2 percent, based
on two years of historical data. The current market interest rate for loans in this
sector is 12 percent.

a. Using the RAROC model, determine whether the bank should make the
loan?

RAROC = Fees and interest earned on loan/Loan or capital risk

Loan risk, or LN =
-DLN x LN x (R/(1 + R)) = -7.5 x $5m x (0.042/1.12) = -$1,406,250
Expected interest = 0.12 x $5,000,000 = $600,000
Servicing fees = 0.0050 x $5,000,000 = $25,000
Less cost of funds = 0.10 x $5,000,000 = -$500,000
Net interest and fee income = $125,000

RAROC = $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost
of funds to the bank, the bank should not make the loan.
 b. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:

$125,000/LN = 0.10  LN = 125,000 / 0.10 = $1,250,000
 -DLN x LN x (R/(1 + R)) = 1,250,000

DLN = 1,250,000/(5,000,000 x (0.042/1.12)) = 6.67 years.

Thus, this loan can be made if the duration is reduced to 6.67 years from 7.5 years.

c. Assuming that duration cannot be changed, how much additional interest

and fee income will be necessary to make the loan acceptable?

Necessary RAROC = Income/Risk  Income = RAROC x Risk

= $1,406,250 x 0.10 = $140,625
Therefore, additional income = $140,625 - $125,000 = $15,625, or
$15,625/$5,000,000 = 0.003125 = 0.3125%.

Thus, this loan can be made if fees are increased from 50 basis points to 81.25 basis
points.

d. Given the proposed income stream and the negotiated duration, what
adjustment in the loan rate would be necessary to make the loan acceptable?

Need an additional $15,625 => $15,625/$5,000,000 = 0.003125 or 0.3125%

Expected interest = 0.123125 x $5,000,000 = $615,625

Servicing fees = 0.0050 x $5,000,000 = $25,000
Less cost of funds = 0.10 x $5,000,000 = -$500,000
Net interest and fee income = $140,625

RAROC = $140,625/1,406,250 = 10.00 percent = cost of funds to the bank. Thus,

increasing the loan rate from 12% to 12.3125% will make the loan acceptable