7-1.

A government bond is currently selling for $1,195 and pays $75 per year in interest for
14 years when it matures. If the redemption value of this bond is $1,000, what is its yield to
maturity if purchased today for $1,195?

The yield to maturity ( x ) equation for this bond would be:

$75 $ 75 $ 75 $ 75 $ 75 $ 1 , 075
$1,195= 1
+ 2
+ 3
+ 4
+.. .+ +
(1+ YTM ) (1+ YTM) (1+YTM ) (1+YTM) (1+ YTM) (1+ YTM)14
13

Using a financial calculator the YTM = 5.4703 percent.

7-2. Suppose the government bond described in problem 1 above is held for five years and
then the savings institution acquiring the bond decides to sell it at a price of $940. Can you figure
out the average annual yield the savings institution will have earned for its five-year investment
in the bond?

$75 $ 75 $ 75 $ 75 $ 75
$1,195= + + + +
(1+ HPY ) (1+HPY) (1+HPY ) (1+HPY ) (1+HPY )5
1 2 3 4

Using a financial calculator, the HPY is 2.19 percent.

7-3. U.S. Treasury bills are available for purchase this week at the following prices (based
upon $100 par value) and with the indicated maturities:

a. $97.25, 182 days.

b. $95.75, 270 days.
c. $98.75, 91 days.

Calculate the bank discount rate (DR) on each bill if it is held to maturity. What is the equivalent
yield to maturity (sometimes called the bond-equivalent or coupon-equivalent yield) on each of
these Treasury Bills?

The discount rates and equivalent yields to maturity (bond-equivalent or coupon-equivalent

yields) on each of these Treasury bills are:
 Discount Rates Equivalent Yields to Maturity
a.
100 - 97.25 × 360 100 - 97.25 × 365
= 5.44% = 5.67%
100 182 97.25 182

b
100 - 95.75 × 360 100 - 95.75 × 365
= 5.67% = 6.00%
100 270 95.75 270

c.
100 - 98.75 × 360 100 - 98.75 × 365
= 5.08%
100 91 = 4.95% 98.75 91

7-4. Farmville Financial reports a net interest margin of 2.75 percent in its most recent
financial report, with total interest revenue of $95 million and total interest costs of $82 million.
What volume of earning assets must the bank hold? Suppose the bank’s interest revenues rise by
5 percent and its interest costs and earnings assets increase by 9 percent. What will happen to
Farmville’s net interest margin?

The relevant formula is:

$95 mill.  $82 mill.

Net interest margin = 0.0275 = Total earning assets

Then, total earning assets must be $473 million.

If revenues rise by 5 percent, and interest costs and earnings assets rise by 9 percent, net interest
margin is:

$95(1.05)  $82(1.09)
Net interest margin = 473(1.09)

99 .75−89 .38
= 515 .57

= 0.0201 or 2.01 percent

7-5. If a credit union’s net interest margin, which was 2.50 percent, increases 10 percent and
its total assets, which stood originally at $575 million, rise by 20 percent, what change will occur
in the bank's net interest income?

The correct formula is:

 Net interest income
Net interest margin 
Total earning assets

Original net interest income = Net interest margin × Total earning assets
= 2.5% × $575 million = $14.375 million

New net interest income:

Net interest income

0.025 1.10 
$575 million×1.20

Net Interest Income = 0.0275 × 690

= $18.975 million

Change in net interest income = New net interest income – Original net interest income
= $18.975 million - $14.375 million = $4.6 million.

7-6. The cumulative interest rate gap of Poquoson Savings Bank increases 60 percent from an
initial figure of $25 million. If market interest rates rise by 25 percent from an initial level of 3
percent, what changes will occur in this thrift’s net interest income?

New net interest income = New market interest rate × Increase in assets
= 3.75 percent × $40 million = $1.5 million

Initial net interest income = Initial market interest rate × Initial assets
= 3 percent × $25 million = $0.75 million

Percent change in net interest income = ($1.5 million – $0.75 million)/ $0.75 million
= 100 percent

Thus, the bank's net interest income will increase by 100 percent.

7-7. New Comers State Bank has recorded the following financial data for the past three years
(dollars in millions):

Current Year Previous Year Two Years Ago

Interest revenues $82 $80 $78
Interest expenses 64 66 68
Loans (excluding nonperforming) 450 425 400
Investments 200 195 200
Total deposits 450 425 400
Money market borrowings 150 125 100
What has been happening to the bank’s net interest margin? What do you think caused the
changes you have observed? Do you have any recommendations for New Comers’ management
team?

Net interest margin (NIM) = Net interest income/Total earning assets

Where,
Net interest income = Net interest revenues - Net interest expenses
Total earning assets = Loans + Investments

NIM (Current) = ($82-64)/ (450 + 200) = 18/650 = 0.028 or 2.77%

NIM (Previous) = ($80-66)/ (425 + 195) = 14/620 = 0.0226 or 2.26%
NIM (Two years ago) = ($78-68)/ (400 + 200) = 10/600 = 0.0167 or 1.67%

The net interest margin has been increasing over the years. As interest revenues and expenses as
well as the bank’s assets have increased consistently over the years, there has been a constant
increase in the net interest margin. If the bank can further cut down on its interest expenses and
increase its assets in the next years, the net interest margin will increase at a higher rate.

7-8 The First National Bank of Dogsville finds that its asset and liability portfolio contains
the following distribution of maturities and repricing opportunities:

Coming Next 30 Next 31-90 More Than

Week Days Days 90 Days
Loans $200.00 $300.00 $475.00 $525.00
Securities 21.00 26.00 40.00 70.00
Interest-sensitive assets

Transaction deposits $320.00 $ 0.00 $ 0.00 $ 0.00

Time accts. 100.00 290.00 196.00 100.00
Money market borrowings 136.00 140.00 100.00 65.00
Interest-sensitive liabilities

When and by how much is the bank exposed to interest rate risk? For each maturity or repricing
interval, what changes in interest rates will be beneficial and which will be damaging, given the
current portfolio position?

Coming Week Next 30 Next 31-90 More Than 90 Days

Days Days
Loans $200 $300 $475 $525
Securities 21 26 40 70
Total IS Assets $221 $326 $515 $595

Transaction $320 $− $− $−
deposits
Time Accts. 100 290 196 100
Money Mkt. Borr. 136 140 100 65
Total IS Liab. $556 $430 $296 $165

GAP −335 −104 +219 +430

Cumulative GAP −335 −439 −220 +210

First National has a negative gap in the nearest period and therefore would benefit if interest
rates fall. In the next period it has a slightly negative gap and would therefore benefit of interest
rate rise. However, its cumulative gap is still negative. The third period is positive gap and hence
the bank would benefit if interest rates rise. In the final period the gap is positive and the bank
would benefit if interest rates rise. Its cumulative gap is slightly positive and also shows that
rising interest rates would be beneficial to the bank overall.

7-9 Sunset Savings Bank currently has the following interest-sensitive assets and liabilities
on its balance sheet with the interest-rate sensitivity weights noted.

Interest-Sensitive Assets $ Amount Rate Sensitivity Index

Federal fund loans $ 50.00 1.00
Security holdings 50.00 1.20
Loans and leases 350.00 1.45
Interest-Sensitive Liabilities $ Amount Rate Sensitivity Index
Interest-bearing deposits $ 250.00 0.75
Money-market borrowings 90.00 0.95

What is the bank’s current interest-sensitive gap? Adjusting for these various interest rate
sensitivity weights what is the bank’s weighted interest-sensitive gap? Suppose the federal funds
interest rate increases or decreases 50 basis points. How will the bank’s net interest income be
affected (a) given its current balance sheet makeup and (b) reflecting its weighted balance sheet
adjusted for the foregoing rate-sensitivity indexes?

Dollar IS Gap = ISA - ISL = ($50 + $50 + $350) − ($250 + $90) = $110

Weighted IS Gap   1   $50    1.20    50    1.45    350     0.75    $250    0.95    $90  
 $50  $60  $507.5  $187.5  $85.5
 $617.5  $273
 $344.5

a.) Change in Bank’s Income = IS Gap × Change in interest rates

= ($110) (0.005) = $0.55 million

Using the regular IS Gap; net income will change by plus or minus $550,000

b.) Change in Bank’s Income = Weighted IS Gap × Change in interest rates

= ($344.50) (0.005) = $1.72250
Using the weighted IS Gap; net income will change by plus or minus $1,722,500.

7-10 Sparkle Savings Association has interest-sensitive assets of $400 million, interest-
sensitive liabilities of $325 million, and total assets of $500 million. What is the bank’s dollar
interest-sensitive gap? What is Sparkle’s relative interest-sensitive gap? What is the value of its
interest-sensitivity ratio? Is it asset sensitive or liability sensitive? Under what scenario for
market interest rates will Sparkle experience a gain in net interest income? A loss in net interest
income?
Dollar Interest-Sensitive Gap = ISA – ISL = $400 million − $325 million = $75 million

Relative IS Gap = ISA – ISL = $75 = 0.15

Bank Size $500

Interest-Sensitivity Ratio = ISA = $400 = 1.23

ISL $325

Here, the interest sensitivity gap is positive and asset sensitive as the interest sensitive assets are
greater than interest sensitive liabilities. Sparkle Savings Association, being an asset sensitive
financial firm, will have a positive relative IS gap and an interest-sensitivity ratio greater than 1.
In case of a positive IS gap, there will be a gain in net interest income if the market interest rates
are rising. For a positive IS gap, there will be a loss in net interest income, if the market interest
rates are falling.

7-11 Snowman Bank, N.A., has a portfolio of loans and securities expected to generate cash
inflows for the bank as follows:

Expected Cash Inflows of Annual Period in Which Cash Receipts

Principal and Interest Are Expected
Payments

$1,275,600 Current year

746,872 Two years from today
341,555 Three years from today
62,482 Four years from today
9,871 Five years from today

Deposits and money market borrowings are expected to require the following cash outflows:

Expected Cash Outflows of Annual Period during Which Cash

Principal and Interest Payments Must Be Made
Payments

$1,295,500 Current year

831,454 Two years from today
123,897 Three years from today
1,005 Four years from today
 ----- Five years from today

If the discount rate applicable to the previous cash flows is 4.25 percent, what is the duration of
the Snowman’s portfolio of earning assets and of its deposits and money market borrowings?
What will happen to the bank's total returns, assuming all other factors are held constant, if
interest rates rise? If interest rates fall? Given the size of the duration gap you have calculated, in
what type of hedging should Snowman engage? Please be specific about the hedging transactions
needed and their expected effects.

Snowman has asset duration of:

( $1,275,600×1 ) ( $746,872 × 2 ) ( $341,555 × 3 ) ( $62,482 × 4 ) ( $9,871 × 5 )

+ + + +
(1 + 0 . 0425 )1 (1 + 0 . 0425 )2 (1 + 0 . 0425 )3 (1 + 0 .0425 )4 (1 + 0 . 0425)5
DA =
( $1,275,600 ) ( $746,872 ) ( $341,555 ) ( $62,482 ) ( $9,871 )
+ + + +
(1 + 0 . 0425 ) (1 + 0 . 0425) (1 + 0 . 0425) (1 + 0 . 0425) (1 + 0 .0425 )5
1 2 3 4

= $3, 754,097 / $2,273,192= 1.6515 years

Snowman has a liability duration of:

( $1,295,500×1 ) ( $831,454 × 2 ) ( $123,897 × 3 ) ( $1,005 × 4 )

1
+ 2
+ 3
+
(1 + 0 .0425 ) (1 + 0 .0425 ) (1 + 0 .0425 ) (1 + 0 . 0425)4
DL =
( $1,295,500 ) ( $831,454 ) ( $123,897 ) ( $1,005 )
+ + +
(1 + 0 . 0425) (1 + 0 .0425 ) (1 + 0 .0425 ) (1 + 0 .0425 )4
1 2 3

= $3,104,236 / $2,117,934 = 1.4657 years

Snowman's duration gap = Dollar-weighted duration of asset portfolio − Dollar-weighted

duration of liability portfolio = 1.6515 − 1.4657 = 0.1858 years.

Because Snowman's Asset Duration is greater than its Liability Duration, the bank has a positive
duration gap, which means that the bank's net worth will decrease if interest rates rise, because
the value of the liabilities will decline by less than the value of the assets. On the other hand, if
interest rates were to fall, this positive duration gap will increase the net worth. In this case, the
value of the assets will rise by a greater amount than the value of the liabilities.

Given the magnitude of the duration gap, the management of Snowman Bank, needs to do a
combination of things to close its duration gap between assets and liabilities. If the interest rates
are rising, it probably needs to try to shorten asset duration and lengthen liability duration to
move towards a negative duration gap. The opposite is true if interest rates are expected to fall.
The bank can use financial futures or options to deal with whatever asset-liability gap exists at
the moment. The bank may want to consider securitization or selling some of its assets,
reinvesting the cash flows in maturities that will more closely match its liabilities' maturities. The
bank may also consider negotiating some interest-rate swaps to change the cash flow patterns of
its liabilities to more closely match its asset maturities.

7-12. Given the cash inflow and outflow figures in Problem 11 for Snowman Bank, N.A.,
suppose that interest rates began at a level of 4.25 percent and then suddenly rise to 4.75 percent.
If the bank has total assets of $20 billion and total liabilities of $18 billion, by how much would
the value of Snowman’s net worth change as a result of this movement in interest rates?
Suppose, on the other hand, that interest rates decline from 4.25 percent to 3.5 percent. What
happens to the value of Snowman’s net worth in this case and by how much in dollars does it
change? What is the size of its duration gap?

From Problem #11 we find that Snowman's average asset duration is 1.6515 years and average
liability duration is 1.5223 years. If total assets are $20 billion and total liabilities are $18 billion,
then Snowman’ has a leverage-adjusted duration gap of:

$18 bill.
1.6515 – 1.4657 × $20 bill. = 0.1163

The change in Snowman's net worth would be calculated as:

 Δr   Δr 
 D A  (1+r)  A     D L  (1+r)  L 
Change in Value of Net Worth =    

If interest rates increase from 4.25 to 4.75 percent, change in net worth will be:
 0.005   0.005 
  1.6515   20    1.4657   18
 (1+0.0425)   (1+0.0425) 
 0.1584  (0.1265)
= − 0.0319 billion

There is a decrease in the net worth of Snowman with the increase in the interest rate.

If interest rates fall from 4.25 percent to 3.5 percent, change in net worth will be:

 0.0075   0.0075 
  1.6515   20    1.4657   18
 (1+0.0425)   (1+0.0425) 
 0.2376  0.1898
= + 0.0478 billion.

When the interest rates fall, Snowman’s net worth will increase.

7-13. Conway Thrift Association reports an average asset duration of 7 years and an average
liability duration of 4 years. In its latest financial report, the association recorded total assets of
$1.8 billion and total liabilities of $1.5 billion. If interest rates began at 5 percent and then
suddenly climbed to 6 percent, what change will occur in the value of Conway’s net worth? By
how much would Conway’s net worth change if, instead of rising, interest rates fell from 5
percent to 4.5 percent?

The key formula is:

 Δr   Δr 
 D A  (1+r)  A     D L  (1+r)  L 
Change in net worth =    

For the change in interest rates from 5 to 6 percent, change in net worth will be:
 0.01   0.01 
  7   1.8   1.4657   1.5
 (1+0.05)   (1+0.05) 
= – $0.12 billion – (–$0.05714 billion)
= – $0.06286 billion

On the other hand, if interest rates decline from 5 to 4.5 percent, change in net worth will be:
 0.005   0.005 
  7   1.8   1.4657   1.5
 (1+0.05)   (1+0.05) 
= + $0.06 billion – $0.02857 billion
= + $0.03143 billion

7-14. A financial firm holds a bond in its investment portfolio whose duration is 15 years. Its
current market price is $975. While market interest rates are currently at 6 percent for
comparable quality securities, a decrease in interest rates to 5.75 percent is expected in the
coming weeks. What change (in percentage terms) will this bond’s price experience if market
interest rates change as anticipated?

Change in price is computed as follows:

P r
 D *
P (1  r)
0.0025
 15 
 1  0.06  = 3.54 percent

This bond’s price will approximately increase by 3.54 percent or to $1,009.515.

7-15. A savings bank’s weighted average asset duration is 8 years. Its total liabilities amount to
$925 million, while its assets total 1.25 billion dollars. What is the dollar-weighted duration of
the bank’s liability portfolio if it has a zero leverage-adjusted duration gap?

Given the bank has a duration gap equal to zero:

Total Liabilities
= DA - DL 
Duration Gap Total Assets
1.250
0 = 8 - DL 
0.925
0 = 8 - DL  1.351 or DL  1.351  8
8
DL =  5.92 years
1.351
Hence, the dollar-weighted duration of the bank’s liability portfolio is 5.92 years.

7-16 Blue Moon National Bank holds assets and liabilities whose average durations and dollar
amounts are as shown in this table:

Avg. Duration Dollar Amount

Asset and Liability Items (years) (millions)

Investment Grade Bonds 15.00 $65.00

Commercial Loans 3.00 $400.00
Consumer Loans 7.00 $250.00
Deposits 1.25 $600.00
Nondeposit Borrowings 0.50 $50.00

What is the weighted average duration of Blue Moon’s asset portfolio and liability portfolio?
What is the leverage-adjusted duration gap?

The weighted average duration of Blue Moon’s asset portfolio is calculated as follows:
65 400 250
D A   Wi  Di  15  3  7  1.3636 1.6783  2.4476  5.4895 years
715 715 715

The weighted average duration of the liability portfolio is calculated as follows:

600 50
D L   Wi  Di  1.25   0.50  1.1538  0.0385  1.192 years
650 650

TL 650
Leverage-adjusted duration gap  D A  D L   5.4895  1.192   4.4055 years
TA 715
Therefore, the leverage-adjusted duration gap is 4.4055 years.

7-17 A government bond currently carries a yield to maturity of 6 percent and a market price
of $1,168.49. If the bond promises to pay $100 in interest annually for five years, what is its
current duration?

The duration of the bond is computed as follows:

($100  1) ($100  2) ($100  3) ($100  4) ($1,100  5)
   
(1  .06)1 (1  .06) 2 (1  .06)3 (1  .06) 4 (1  .06)5 4,950.98
D  
$100 $100 $100 $100 $1,100 1,168.5
   
(1  .06) (1  .06) (1  .06) (1  .06) (1  .06)
1 2 3 4 5

Therefore, the current duration of the bond is 4.23 years.