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IBA-MBA-Home Assignment-2-Solution

The document contains solutions to 8 problems related to interest rate risk and gap analysis for banks. Problem 1 calculates the dollar interest-sensitive gap, relative gap, and interest sensitivity ratio for a bank. Problem 2 determines how a change in interest rates would affect net interest income given a bank's cumulative interest rate gap. Problem 3 identifies whether a bank is asset sensitive or liability sensitive based on its interest rate gaps.

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Ibrahim Badsha
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302 views6 pages

IBA-MBA-Home Assignment-2-Solution

The document contains solutions to 8 problems related to interest rate risk and gap analysis for banks. Problem 1 calculates the dollar interest-sensitive gap, relative gap, and interest sensitivity ratio for a bank. Problem 2 determines how a change in interest rates would affect net interest income given a bank's cumulative interest rate gap. Problem 3 identifies whether a bank is asset sensitive or liability sensitive based on its interest rate gaps.

Uploaded by

Ibrahim Badsha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Home assignment (problem oriented)-2 solution

FIN 703
1. Suppose Carroll Bank and Trust reports interest-sensitive assets of $570
million and interest-sensitive liabilities of $685 million. What is the bank’s
dollar interest-sensitive gap? Its relative interest-sensitive gap and interest-
sensitivity ratio?
Ans:
𝐷𝑜𝑙𝑙𝑎𝑟 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐺𝑎𝑝
= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐴𝑠𝑠𝑒𝑡𝑠 – 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
= $570 − $685 = −$115
$ 𝐼𝑆 𝐺𝑎𝑝 −$115
𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝐺𝑎𝑝 = = = −0.2018 𝑜𝑟 − 20.18 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
𝐵𝑎𝑛𝑘 𝑆𝑖𝑧𝑒 $570
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡−𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐴𝑠𝑠𝑒𝑡𝑠 $570
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = = = .8321
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡−𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 $685

2. The cumulative interest-rate gap of Jamestown Savings Bank increases 75


percent from an initial figure of $22 million. If market interest rates rise by 25
percent from an initial level of 4.5 percent, what change will occur in this
thrift’s net interest income?
Ans: The key formula here is:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
= 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 (𝑖𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑝𝑜𝑖𝑛𝑡𝑠)
∗ 𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑔𝑎𝑝
𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = (0.045 ∗ .25)𝑥 ($22 𝑚𝑖𝑙𝑙. ) ∗ (1 + .75) = $. 433𝑚

Thus, the bank's net interest income will rise by $0.433million.

3. Commerce National Bank reports interest-sensitive assets of $870 million


and interest-sensitive liabilities of $625 million during the coming month. Is the
bank asset sensitive or liability sensitive? What is likely to happen to the bank’s
net interest margin if interest rates rise? If they fall?
Ans. Because interest-sensitive assets are larger than liabilities by $245 million
the bank is asset sensitive.
If interest rates rise, the bank's net interest margin should rise as asset
revenues increase by more than the resulting increase in liability costs.
On the other hand, if interest rates fall, the bank's net interest margin will fall
as asset revenues decline faster than liability costs.

4. If a credit union’s net interest margin, which was 2.50 percent, increases 15
percent and its total assets, which stood originally at $625 million, rise by 20
percent, what change will occur in the bank's net interest income?
Ans: The correct formula is:
𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑛𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠)

𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒


. 025 ∗ (1 + .15) =
$625 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ∗ (1 + .2)
𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 0.02875 ∗ $750 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = $21.5625 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.

5. Twinkle Savings Association has interest-sensitive assets of $325 million,


interest-sensitive liabilities of $325 million, and total assets of $500 million.
What is the bank’s dollar interest-sensitive gap? What is Twinkle’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 Twinkle experience a gain in net interest income? A loss in net
interest income?
Solution: 𝐷𝑜𝑙𝑙𝑎𝑟 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐺𝑎𝑝
= 𝐼𝑆𝐴 – 𝐼𝑆𝐿 = $325 − $325 = $0
𝐼𝑆𝐴 − 𝐼𝑆𝐿 $0
𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝐺𝑎𝑝 = = =0
𝐵𝑎𝑛𝑘 𝑆𝑖𝑧𝑒 $500
𝐼𝑆𝐴 $325
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = = =1
𝐼𝑆𝐿 $325
6. First National Bank of Bannerville has posted interest revenues of $63
million and interest costs from all of its borrowings of $42 million. If this bank
possesses $700 million in total earning assets, what is First National’s net
interest margin? Suppose the bank’s interest revenues and interest costs
double, while its earning assets increase by 50 percent. What will happen to its
net interest margin?
Solution: First National Bank of Bannerville has posted the following financial
statement entries:
Interest revenues=$63 million, Interest costs=$42 million,
Total earning assets=$700 million.
The bank's net interest margin must be:
$63 𝑚𝑖𝑙𝑙. − $42 𝑚𝑖𝑙𝑙.
𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = = 0.03 𝑜𝑟 3 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
$700 𝑚𝑖𝑙𝑙

If interest revenues and interest costs double while earning assets grow by 50
percent, the net interest margin will change as follows:
($63 𝑚𝑖𝑙𝑙. − $42 𝑚𝑖𝑙𝑙. ) ∗ 2
= 0.04 𝑜𝑟 4 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
$700 𝑚𝑖𝑙𝑙. ∗ (1.50)
Clearly the net interest margin increases, in this case by one third.

7. Peoples’ Savings Bank has a cumulative gap for the coming year of + $135
million and interest rates are expected to fall by two and a half percentage
points. Can you calculate the expected change in net interest income that this
thrift institution might experience? What change will occur in net interest
income if interest rates rise by one and a quarter percentage points?
Ans. We know, the key relation between cumulative gap and interest income
is,
∆ 𝑖𝑛 𝑛𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
= ∆ 𝑖𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 ∗ 𝑆𝑖𝑧𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑔𝑎𝑜
When interest rates are expected to fall by two and a half percentage points,
Expected Change in
= $𝟏𝟑𝟓 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 ∗ (−𝟎. 𝟎𝟐𝟓) = − $𝟑. 𝟑𝟖 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
Net Interest Income
What change will occur in net interest income if interest rates rise by one and a
quarter percentage points?
Expected Change in
= $𝟏𝟑𝟓 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 ∗ (+. 𝟎𝟏𝟐𝟓) = + $𝟏. 𝟔𝟗 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
Net Interest Income

8. Given the that Richman Bank, N.A. has average asset duration is 1.5903
years and average liability duration is 1.4075 years. Suppose that interest rates
began at a level of 5 percent and then suddenly rise to 5.75 percent. If the
bank has total assets of $5 billion and total liabilities of $4.5 billion, by how
much would the value of Richman’s net worth changes as a result of this
movement in interest rates? Suppose, on the other hand, that interest rates
decline from 5 percent to 4.5 percent. What happens to the value of Richman’s
net worth in this case and by how much in dollars does it change? What is the
size of its duration gap?
Ans: Richman’s duration gap is:
$4.5 𝑏𝑖𝑙𝑙
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝐺𝑎𝑝 = 1.5903 – 1.4075 ∗ = 1.5903 – 1.26675 = 0.3236
$5 𝑏𝑖𝑙𝑙

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑵𝒆𝒕 𝑾𝒐𝒓𝒕𝒉 =


𝜟𝒊 𝜟𝒊
𝜟𝑵𝑾 = [−𝑫𝑨 × (𝟏+𝒊) × 𝑨] − [−𝑫𝑳 × (𝟏+𝒊) × 𝑳]

If interest rate change from 5% to 5.75%, then change in net worth would be:
.𝟎𝟎𝟕𝟓 .𝟎𝟎𝟕𝟓
𝜟𝑵𝑾 = [−𝟏. 𝟓𝟗𝟎𝟑 × (𝟏+𝟎𝟓) × 𝟓] − [−𝟏. 𝟒𝟎𝟕𝟓 × (𝟏±𝟎𝟓) × 𝟒. 𝟓]

= −. 𝟎𝟓𝟔𝟖𝟎+. 𝟎𝟒𝟗𝟖𝟖 = −. 𝟎𝟎𝟔𝟗𝟐 𝒃𝒊𝒍𝒍𝒊𝒐𝒏


If interest rate change from 5% to 4.5%, then change in net worth would be:
−.𝟎𝟎𝟓 −.𝟎𝟎𝟓
𝜟𝑵𝑾 = [−𝟏. 𝟓𝟗𝟎𝟑 × (𝟏+𝟎𝟓) × 𝟓] − [−𝟏. 𝟒𝟎𝟕𝟓 × (𝟏±𝟎𝟓) × 𝟒. 𝟓]

= + 𝟎. 𝟎𝟑𝟕𝟖𝟔 – 𝟎. 𝟎𝟑𝟎𝟏𝟔
= + 𝟎. 𝟎𝟎𝟕𝟕𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏.
9. Watson Thrift Association reports an average asset duration of 7 years, an
average liability duration of 3.25 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 6 percent and then suddenly climbed to 7.5
percent, what change (in percentage terms) wills this bond’s price experience
if market interest rates change as anticipated?
Solution: The key formula is:
𝜟𝒊 𝜟𝒊
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ=𝜟𝑵𝑾 = [−𝑫𝑨 × (𝟏+𝒊) × 𝑨] − [−𝑫𝑳 × (𝟏+𝒊) × 𝑳]

For the change in interest rates from 6 to 7.5 percent, Watson's net worth will
change to:

= −$178.30 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + $68.99 𝑚𝑖𝑙𝑙𝑖𝑜𝑛


= −$109.31 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

On the other hand, if interest rates decline from 6 to 5 percent we have:

= + $118.87 𝑚𝑖𝑙𝑙. − $45.99 𝑚𝑖𝑙𝑙.


= + $72.88 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

10. A financial firm holds a bond in its investment portfolio whose duration is
13.5 years. Its current market price is $950. While market interest rates are
currently at 7 percent for comparable quality securities, a decrease in interest
rates to 6.75 percent is expected in the coming weeks. What changes (in
percentage terms) will this bond’s price experience if market interest rates
change as anticipated?

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