BANK3011 Workshop Week 3 – Suggested End of Chapter 8 Solutions

1. What is the repricing gap? In using this model to evaluate interest rate risk, what is meant
by rate sensitivity? On what financial performance variable does the repricing model focus?
Explain.

The repricing gap is a measure of the difference between the dollar value of assets that will
reprice and the dollar value of liabilities that will reprice within a specific time period, where
reprice means the potential to receive or attract a new interest rate. Rate sensitivity represents
the time interval where repricing can occur. The model focuses on the potential changes in the
net interest income variable. In effect, if interest rates change, interest income and interest
expense will change as the various assets and liabilities are repriced, that is, receive new
interest rates.

2. What is the CGAP effect? According to the CGAP effect, what is the relation between changes
in interest rates and changes in net interest income when CGAP is positive? When CGAP is
negative?

The CGAP effect describes the relation between changes in interest rates and changes in net
interest income. According to the CGAP effect, when CGAP is positive the change in NII is
positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive
when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative
the change in NII is negatively related to the change in interest rates. Thus, an FI would want its
CGAP to be negative when interest rates are expected to fall.

3. 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?

According to the CGAP effect, when GAP, or CGAP, is positive the change in NII is positively
related to the change in interest rates. Thus, an FI would want its GAP to be positive when
interest rates are expected to rise.

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

Yes. This change will increase RSAs, which will increase GAP.

b. Replace marketable securities with fixed-rate loans

No. This change will decrease RSAs, which will decrease GAP.

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

No. This change will increase RSLs, which will decrease GAP.

d. Replace vault cash with marketable securities

Yes. This change will increase RSAs, which will increase GAP.

4. Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test?

3-month U.S. Treasury bills Yes

 1-year U.S. Treasury notes Yes
20-year U.S. Treasury bonds No
20-year floating-rate corporate bonds with annual repricing Yes
30-year floating-rate mortgages with repricing every two years No
30-year floating-rate mortgages with repricing every six months Yes
Overnight fed funds Yes
9-month fixed-rate CDs Yes
1-year fixed-rate CDs Yes
5-year floating-rate CDs with annual repricing Yes
Common stock No

5. 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 at year-end?

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 net interest income be at year-end if interest rates rise by 2 percent?

After the 2 percent interest rate increase, net interest income declines to
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 CGAP*∆R= (-$20m)(0.02) = -$0.4m.
 d. What will net interest income be at year-end 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(.07) = $9.5m - $6.3m = $3.2m, an increase of $0.3m.

Alternatively, RSA*∆RRSA-RSL*∆RRSL=$50m*0.02-$70m*0.01 = $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.

6. What are some of the weakness of the repricing model? How have large banks solved the
problem of choosing the optimal time period for repricing? What is runoff cash flow, and
how does this amount affect the repricing model’s analysis?

The repricing model has four general weaknesses:

(1) It ignores market value effects.

(2) It does not take into account the fact that the dollar value of rate-sensitive assets
and liabilities within a bucket are not similar. Thus, if assets, on average, are repriced
earlier in the bucket than liabilities, and if interest rates fall, FIs are subject to
reinvestment risks.

(3) It ignores the problem of runoffs. That is, that some assets are prepaid and some
liabilities are withdrawn before the maturity date.

(4) It ignores income generated from off-balance-sheet activities.

Large banks are able to reprice securities every day using their own internal models so
reinvestment and repricing risks can be estimated for each day of the year.

Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are
withdrawn unexpectedly. To the extent that either of these amounts is significantly greater
than expected, the estimated interest rate sensitivity of the FI will be in error.
7. County Bank has the following market value balance sheet (in millions, all interest at annual
rates). All securities are selling at par equal to book value.

Assets Liabilities and Equity

Cash $20 Demand deposits $100

15-year commercial loan at 10% 5-year CDs at 6% interest,

interest, balloon payment 160 balloon payment 210

30-year mortgages at 8% interest, 20-year debentures at 7% interest, 120

balloon payment 300 balloon payment

Equity 50

Total assets $480 Total liabilities & equity $480

a. What is the maturity gap for County Bank?

MA = [0x$20 + 15x$160 + 30x$300]/$480 = 23.75 years.

ML = [0x$100 + 5x$210 + 20x$120]/$430 = 8.02 years.

MGAP = 23.75 – 8.02 = 15.73 years.

b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1
percent?
If interest rates increase one percent, the value and average maturity of the assets will be:

Cash = $20

Commercial loans = $16xPVAn=15, i=11% + $160xPVn=15,i=11% = $148.49

Mortgages = $24xPVAn=30,i=9% + $300xPVn=30,i=9% = $269.18

MA = [0x$20 + 15x$148.49 + 30x$269.18]/($20 + $148.49 + $269.18) = 23.54 years

The value and average maturity of the liabilities will be:

Demand deposits = $100

CDs = $12.60xPVAn=5,i=7% + $210xPVn=5,i=7% = $201.39

Debentures = $8.4xPVAn=20,i=8% + $120xPVn=20,i=8% = $108.22

ML = [0x$100 + 5x$201.39 + 20x$108.22]/($100 + $201.39 + $108.22) = 7.74 years

The maturity gap = MGAP = 23.54 – 7.74 = 15.80 years. The maturity gap increased because the
average maturity of the liabilities decreased more than the average maturity of the assets. This
result occurred primarily because of the differences in the cash flow streams for the mortgages
and the debentures.
8. What will happen to the market value of the equity?

The market value of the assets has decreased from $480 to $437.67, or $42.33. The market
value of the liabilities has decreased from $430 to $409.61, or $20.39. Therefore, the market
value of the equity will decrease by $42.33 - $20.39 = $21.94, or 43.88 percent.

25. If a bank manager is certain that interest rates were going to increase within the next six
months, how should the bank manager adjust the bank’s maturity gap to take advantage of
this anticipated increase? What if the manager believes rates will fall? Would your suggested
adjustments be difficult or easy to achieve?

When rates rise, the value of the longer-lived assets will fall by more the shorter-lived liabilities.
If the maturity gap is positive, the bank manager will want to shorten the maturity gap or make
it negative. If the maturity gap is negative, the manager might do nothing. If rates are expected
to decrease, the manager should reverse these strategies. Changing the maturity on the balance
sheet often involves changing the mix of assets and liabilities. Attempts to make these changes
may involve changes in financial strategy for the bank which may not be easy to accomplish.