Week 2 Reading and Practice Questions - Interest Rate Risk I

Week 2 Reading Guide and Practice Questions
Textbook Reading
Lange, Saunders, and Cornett - Financial Institutions Management: A Risk Management

Approach 4th edition
Chapter 3: The financial service industry – other financial institutions (only sections that are
related to the lecture content)
Chapter 5: Interest rate risk – the repricing model (Page 142 -158)
Chapter 6: Interest rate risk – the duration model (Page 170 - 183)
Or
Saunders and Cornett - Financial Institutions Management: A Risk Management Approach 9th
edition
Chapter 3 – 6: Financial services (only sections that are related to the lecture content)
Chapter 8: Interest rate risk I (Page 200 - 215)
Chapter 9: Interest rate risk II (Page 231 - 245)
Past exam questions
1. Interest rate risk – repricing model
Consider the following re-pricing buckets and gaps of a bank:

Repricing bucket Assets Liabilities
1 to 6 months $250,000 $290,000
6 to 12 months $250,000 $80,000
1 to 3 years $75,000 $130,000
3 to 5 years $25,000 $100,000
1) What is the annualized change in the bank’s future net interest income if the interest rates
for all assets and liabilities that can be re-priced within one year are decreased by 10 basis
points on average?
2) Assume that the following amounts of runoff occur within one-year:

a) $15,000 for liabilities in the bucket of 1-3 years;
b) $5,000 for assets in the bucket of 3-5 years.
Adjusting for runoff, what is the annualized change in the bank’s future net interest income if
the interest rates for assets and liabilities that can be re-priced within 1 year increase by 50
basis points on average?
2. Duration calculation:
Annual coupon bonds:
A bank issues a bond with the following terms: 1) $1000 face value, 2) 3-year maturity and 3)
10% annual coupon rate. The current market interest rate is 10% per annum. What is the
bond’s duration?
Non-annual coupon bonds:

A bank issues a bond with the following terms: 1) $1000 face value, 2) 2-year maturity and 3)
10% annual coupon rate. The bond is issued at par. And the coupon payments are paid semi-
annually. Which one of the following answers is closest to the bond’s duration?
3. There are four bonds which have the same time to maturity and yield to maturity, but they
differ in couple rate and coupon payment frequency. Bond A pays an annual coupon of 10%,
bond B pays a semi-annual coupon of 6% twice per year, bond C pays an annual coupon of 12%,
and bond D pays a semi-annual coupon of 5% twice per year. Which one of the four bonds has
the shortest duration?
End-of-chapter questions
Chapter 3 – The financial service industry: other financial institutions
Q4. Contrast the balance sheet of DIs with that of a typical life insurance company, a money market
company and a managed fund.
Chapter 5 – Interest rate risk: the repricing model
Q4. What is a maturity bucket in the repricing model? Why is the length of time selected for repricing
assets and liabilities important when using the repricing model?
Q6. Calculate the repricing gap and impact on net interest income of a 1 per cent increase in interest rates for
the following positions:
(a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million.
(b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million.
(c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million.
(d) Compare the interest rate risk exposure of the institutions in parts (a), (b) and (c).
Q8. Which of the following is an appropriate change to make on a bank’s balance sheet when GAP is
negative, spread is expected to remain unchanged and interest rates are expected to rise?
(a) Replace fixed-rate loans with rate-sensitive loans.
(b) Replace marketable securities with fixed-rate loans.
(c) Replace fixed-rate CDs with rate-sensitive CDs.
(d) Replace equity with demand deposits.
(e) Replace vault cash with marketable securities.
Q9. If a bank manager was quite certain that interest rates were going to rise within the next six months,
how should the bank manager adjust the bank’s six-month repricing gap to take advantage of this
anticipated rise? What if the manger believed rates would fall in the next six months?
Q11. What are the reasons for not including savings account demand deposits as rate-sensitive liabilities
in the repricing analysis for a commercial bank? What is the subtle but potentially strong reason for
including savings account demand deposits in the total of rate-sensitive liabilities? Can the same
argument be made for other on-demand deposit accounts?
Integrated mini case: Calculating and using the repricing GAP
Allied National Bank’s balance sheet is listed below. Market yields are in parenthesis, and amounts are in
millions.
Assets Million Liabilities and equity Million

Cash 20 Demand deposits 250
Interbank lending (5.05%) 150 Savings accounts (1.5%) 20
3-month T-notes (5.25%) 150 Money market deposit accounts 340
(4.5%) (no minimum balance
requirement)
2-year T-Bonds (6.50%) 100 3-month CDs (4.2%) 120
8-year T-Bonds (7.50%) 200 6-month CDs (4.3%) 220
5-year corporate bonds (floating 50 1-year CDs (4.5%) 375
rate) (8.20%, repriced @ 6
months)
6-month consumer loans (6%) 250 2-year CDs (5%) 425
1-year consumer loans (5.8%) 300 4-year CDs (5.5%) 330
5-year personal loans (7%) 350 5-year CDs (6%) 350
7-month commercial loans (5.8%) 200 Interbank borrowings (5%) 225
2-year commercial loans (floating 275 Overnight repos (5%) 290
rate) (5.15%, repriced @ 6-
months)
15-year variable rate mortgages 200 6-month bank accepted bills 300
(5.8%, repriced @ 6-months) (5.05%)
15-year variable rate mortgages 400 Subordinate notes: 3-year fixed 200
(6.1%, repriced @ year) rate (6.55%)
15-year fixed-rate mortgages 300 Subordinated debt: 7-year fixed 100
(7.85%) rate (7.25%)
30-year variable rate mortgages 225 Total liabilities 3545
(6.3%, repriced @ quarter)
30-year variable rate mortgages 355
(6.4%, repriced @ month)
30-year fixed-rate mortgages 400
(8.2%)
Premises and equipment 20 Equity 400
Total assets $3945 Total liabilities and equity $3945
(a) What is the repricing gap if the planning period is 30 days? 6 months? 1 year? 2 years?
5 years?
(b) What is the impact over the next six months on net interest income if interest rates on RSAs increase
60 basis points and on RSLs increase 40 basis points?
(c) What is the impact over the next year on net interest income if interest rates on RSAs increase 60 basis
points and on RSLs increase 40 basis points?
Chapter 6 – Interest rate risk: introduction to duration
Q3. A one-year, $100 000 loan carries a coupon rate and a market interest rate of 12 per cent. The loan
requires payment of accrued interest and one-half of the principal at the end of six months. The
remaining principal and accrued interest are due at the end of the year.
(a) What will be the cash flows at the end of six months and at the end of the year?
(b) What is the present value of each cash flow discounted at the market rate? What is the total present
value?
(c) What proportion of the total present value of cash flows occurs at the end of six months? What
proportion occurs at the end of the year?
(d) What is the duration of this loan?
Q4. Two bonds are available for purchase in the financial markets. The first bond is a two-year, $1000 bond
that pays an annual coupon of 10 per cent. The second bond is a two-year, $1000, zero-coupon bond.

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Week 2 Reading Guide and Practice Questions

Lange, Saunders, and Cornett - Financial Institutions Management: A Risk Management

Past exam questions

1. Interest rate risk – repricing model

Consider the following re-pricing buckets and gaps of a bank:

2) Assume that the following amounts of runoff occur within one-year:

Non-annual coupon bonds:

Chapter 3 – The financial service industry: other financial institutions

Chapter 5 – Interest rate risk: the repricing model

(a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million.

(b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million.

(c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million.

(a) Replace fixed-rate loans with rate-sensitive loans.

(b) Replace marketable securities with fixed-rate loans.

(c) Replace fixed-rate CDs with rate-sensitive CDs.

(d) Replace equity with demand deposits.

(e) Replace vault cash with marketable securities.

Assets Million Liabilities and equity Million

(d) What is the duration of this loan?

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