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Chapter Five The Financial Statements of Banks and Their Principal Competitors 155

outstanding (including deposits and nondeposit borrowings), and capital or stockhold-

ers’ equity. The values recorded on the balance sheet are measured at a single moment
in time (such as the last day of the quarter or year).
• In contrast, the income and expense statement or Report of Income includes key sources
of revenue and operating expenses. Revenue sources for most financial firms typically
include loan and investment income and revenue from the sale of fee-generating
services. Major sources of operating expense include interest payments on borrowed
funds, employee wages, salaries and benefits, taxes, and miscellaneous expenses.
• The financial statements of nonbank financial firms (including thrift institutions, life
and property/casualty insurers, and security firms) are increasingly coming to resem-
ble bank financial statements and vice versa as these different industries rush toward
each other. Among the common features are heavy use of financial leverage (debt) to
finance their operations, the dominance of financial assets over real (physical) assets,
and the concentration of revenues from making loans and assisting businesses in selling
their securities. For most financial firms the key expense is usually interest expense on
borrowings, followed by personnel costs.
• By carefully reading the financial statements of banks and their competitors we learn
more about the services these institutions provide and how their financial condition
changes with time. These statements, when accurately prepared, provide indispensable

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information to managers, owners, creditors, and regulators of financial-service
providers. Unfortunately, some financial institutions engage in “window dressing” and
other forms of data manipulation, which can send out misleading information.

Key Terms Report of Condition, 131 Report of Income, 145

Problems 1. Norfolk National Bank has just submitted its Report of Condition to the FDIC. Please
and Projects fill in the missing items from its statement shown below (all figures in millions of dollars):

Report of Condition
Total assets $4,000.00
Cash and due from depository institutions 90.00
Securities 535.00
Federal funds sold and reverse repurchase agreements 45.00
Gross loans and leases 2900
Loan loss allowance 200.00
Net loans and leases 2,700.00
Trading account assets 20.00
Bank premises and fixed assets 220
Other real estate owned 15.00
Goodwill and other intangibles 200.00
All other assets 175.00
Total liabilities and capital 4000
Total liabilities 3580
Total deposits 2920
Federal funds purchased and repurchase agreements 80.00
Trading liabilities 10.00
Other borrowed funds 50.00
Subordinated debt 480.00
All other liabilities 40.00
Total equity capital 420
Perpetual preferred stock 5.00
Common stock 25.00
Surplus 320.00
Undivided profits 70.00

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156 Part Two Financial Statements and Financial-Firm Performance

2. Along with the Report of Condition submitted above, Norfolk has also prepared a
Report of Income for the FDIC. Please fill in the missing items from its statement
shown below (all figures in millions of dollars):
Report of Income
Total interest income $200
Total interest expense 140
Net interest income 60
Provision for loan and lease losses 20 (60+100-125-15)
Total noninterest income 100
Fiduciary activities 20
Service charges on deposit accounts 25
Trading account gains & fees 25
Additional noninterest income 30
Total noninterest expense 125
Salaries and employee benefits 95
Premises and equipment expense 10
Additional noninterest expense 20
Pretax net operating income 15
Securities gains (losses) 5
Applicable income taxes 3
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Income before extraordinary items 17 (15+5-3)

Extraordinary gains—net 2
Net income 19

3. If you know the following figures:

Total interest income $140 Provision for loan losses $5

Total interest expenses 100 Income taxes 4
Total noninterest income 75 Increases in bank’s undivided profits 6
Total noninterest expenses 90
Please calculate these items:
Net interest income 40 Total operating revenues 215
Net noninterest income -15 Total operating expenses 100+90+5
Pretax net operating income 40-15-5 Dividends paid to common stockholders 16-6
Net income after taxes 16

4. If you know the following figures:

Gross loans $300 Trading-account securities $2

Allowance for loan losses 15 Other real estate owned 4
Investment securities 36 Goodwill and other intangibles 3
Common stock 5 Total liabilities 375
Surplus 15 Preferred stock 3
Total equity capital 30 Nondeposit borrowings 40
Cash and due from banks 10 Bank premises and equipment, net 20
Miscellaneous assets 25
Bank premises and equipment, gross 25
Please calculate these items:
Total assets 30 + 375 Fed funds sold 20 (only asset left)
Net loans 300 -15 Depreciation 25-20
Undivided profits 30-15-5-3 Total deposits 375-40

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Chapter Five The Financial Statements of Banks and Their Principal Competitors 157

5. The Sea Level Bank has Gross Loans of $800 million with an ALL account of
$45 million. Two years ago the bank made a loan for $12 million to finance the Sun-
set Hotel. Two million dollars in principal was repaid before the borrowers defaulted
on the loan. The Loan Committee at Sea Level Bank believes the hotel will sell at
auction for $7 million and they want to charge off the remainder immediately.
a. The dollar figure for Net Loans before the charge-off is 800 - 45
. = 755
Gross Loans = 800 - (10 - 7) = 797
ALL =45 – (12-2-7) = 42 b. After the charge-off, what are the dollar figures for Gross Loans, ALL, and Net
Net Loans = 797 - 42 = 755 Loans assuming no other transactions?
c. If the Sunset Hotel sells at auction for $10 million, how will this affect the perti-
nent balance sheet accounts?
6. For each of the following transactions, which items on a bank’s statement of income
and expenses (Report of Income) would be affected?
Additional noninterest expense and Total a. Office supplies are purchased so the bank will have enough deposit slips and other
Noninterest Expense.
necessary forms for customer and employee use next week.
Salaries and Benefits and Total Noninterest b. The bank sets aside funds to be contributed through its monthly payroll to the
Expenses
employee pension plan in the name of all its eligible employees.
c. The bank posts the amount of interest earned on the savings account of one of its
customers. total interest expense

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PLL to go into reserves for future bad debts d. Management expects that among a series of real estate loans recently granted the
default rate will probably be close to 3 percent.
Additional Noninterest Income and Total e. Mr. and Mrs. Harold Jones just purchased a safety deposit box to hold their stock
Noninterest Income certificates and wills.
f. The bank collects $1 million in interest payments from loans it made earlier this
year to Intel Composition Corp. Total Interest Income
Service Charges on Deposit Accounts and
g. Hal Jones’s checking account is charged $30 for two of Hal’s checks that were
Total Noninterest Income returned for insufficient funds.
h. The bank earns $5 million in interest on the government securities it has held
since the middle of last year. Total Interest Income.
i. The bank has to pay its $5,000 monthly utility bill today to the local electric
company. Premises and Equipment Expenses and Total Noninterest Expenses
j. A sale of government securities has just netted the bank a $290,000 capital gain
(net of taxes). Security Gains (Losses
7. For each of the transactions described here, which of at least two accounts on
a bank’s balance sheet (Report of Condition) would be affected by each
transaction?
Gross Loans +$6,000 Total Deposits +$6,000 a. Sally Mayfield has just opened a time deposit in the amount of $6,000, and these
funds are immediately loaned to Robert Jones to purchase a used car.
Securities + $1,000 Total Deposits +$1,000 b. Arthur Blode deposits his payroll check for $1,000 in the bank, and the bank
invests the funds in a government security.
c. The bank sells a new issue of common stock for $100,000 to investors living in
Bank Premises & Equipment, Gross +$100,000
its community, and the proceeds of that sale are spent on the installation of new
Common Stock /Surplus +$100,000
ATMs.
d. Jane Gavel withdraws her checking account balance of $2,500 from the bank and
moves her deposit to a credit union; the bank employs the funds received from
Mr. Alan James, who has just paid off his home equity loan, to provide Ms. Gavel
with the funds she withdrew. Gross Loans -$2,500 Total Deposits -$2,500

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f. On the day the funds are loaned the accounts are affected in the following manner:Cash and Due from Bank -$5,000,000 Federal
Funds Sold +$5,000,000 and when the finds are returned the next day, the process is reversed.
158 Part Two Financial Statements and Financial-Firm Performance

Cash and Due from Bank -$750,000 e. The bank purchases a bulldozer from Ace Manufacturing Company for $750,000
Gross Loans and Leases +750,000 and leases it to Cespan Construction Company.
f. Signet National Bank makes a loan of reserves in the amount of $5 million to
Quesan State Bank and the funds are returned the next day.
Gross Loans -$1,000,000 g. The bank declares its outstanding loan of $1 million to Deprina Corp. to be
ALL -$1,000,000 uncollectible.
8. The John Wayne Bank is developing a list of off-balance-sheet items for its call report.
Please fill in the missing items from its statement shown below. Using Table 5–5,
describe how John Wayne compares with other banks in the same size category
regarding its off-balance sheet activities.

Off-balance-sheet items for John Wayne Bank (in millions of $)

Total unused commitments $ 8,000
Standby letters of credit and foreign office guarantees 1,350
(Amount conveyed to others) –50
Commercial letters of credit 60
Securities lent 2,200
Derivatives (total) 100,000
Notional amount of credit derivatives 22,000
Interest rate contracts 54,000
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Foreign exchange rate contracts 100-22-53-1.2 = 22.8

Contracts on other commodities and equities 1,200
All other off-balance-sheet liabilities 49
Total off-balance-sheet items 111609
Total assets (on-balance sheet) 12,000
Off-balance-sheet assets 4 on-balance-sheet assets 9.30075

9. See if you can determine the amount of Bluebird State Bank’s current net income
after taxes from the figures below (stated in millions of dollars) and the amount of its
retained earnings from current income that it will be able to reinvest in the bank. (Be
sure to arrange all the figures given in correct sequence to derive the bank’s Report of
Income.)

Total interest income = 90+9=99 Effective tax rate 28%

Total interest ex = 5+40=45 Interest on loans $90
-> net interest income = 54 Employee wages, salaries, and benefits 13
provision for loan loss: (5) Interest earned on government bonds and notes 9
Total noninterest income= 3+3=6 Provision for loan losses 5
Total noninterest ex = 13+3=16 Overhead expenses 3
-> net non-income = (10) Service charges paid by depositors 3
Pretax income = 54-5-10=39
Security gains/losses 27
tax paid: 28% x 39 = 11
Interest paid on federal funds purchased 5
securities gains/losses: (7)
Net income: 21 Payment of dividends of $4 per share on 1 million outstanding
less dividends: 4 shares to be made to common stockholders
RE: 17 Interest paid to customers holding time and savings deposits 40
Trust department fees 3

10. Which of these account items or entries would normally occur on a bank’s balance
sheet (Report of Condition) and which on a bank’s income and expense statement
(Report of Income)?

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Chapter Five The Financial Statements of Banks and Their Principal Competitors 159

Federal funds sold Deposits due to banks

Addition to undivided Leases of business equipment
profits to customers
Credit card loans
Utility expense Interest received on credit card
loans
Vault cash Fed funds purchased
Allowance for loan losses Savings deposits
Depreciation on premises and equipment Provision for loan losses
Commercial and industrial loans Service charges on deposits
Repayments of credit card loans Undivided profits
Common stock Mortgage owed on the bank’s
buildings
Interest paid on money market deposits Other real estate owned
Securities gains or losses

11. You were informed that a bank’s latest income and expense statement contained the
following figures (in $ millions):

Net interest income $800

Net noninterest income 2500

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Pretax net operating income 372
Security gains 100
Increases in bank’s undivided profits 200

Suppose you also were told that the bank’s total interest income is twice as large as its
total interest expense and its noninterest income is three-fourths of its noninterest
expense. Imagine that its provision for loan losses equals 3 percent of its total inter-
est income, while its taxes generally amount to 30 percent of its net income before
income taxes. Calculate the following items for this bank’s income and expense
statement:

Total interest income 1600

Total interest expenses 800
Total noninterest income 1500
Total noninterest expenses 2000
Provision for loan losses 48
Income taxes 0.3(372+100) = 141.6
Dividends paid to common stockholders (372+100 - 141.6) -200 = 130.4

12. Why do the financial statements issued by banks and by nonbank financial-service
providers look increasingly similar today? Which nonbank financial firms have bal-
ance sheets and income statements that closely resemble those of commercial banks
(especially community banks)?
13. What principal types of assets and funds sources do nonbank thrifts (including sav-
ings banks, savings and loans, and credit unions) draw upon? Where does the bulk of
their revenue come from, and what are their principal expense items?
14. How are the balance sheets and income statements of finance companies, insurers,
and securities firms similar to those of banks, and in what ways are they different?
What might explain the differences you observe?

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420 Part Five Managing Sources of Funds for a Financial Firm

Problems 1. Rhinestone National Bank reports the following figures in its current Report of
Condition:
and Projects
Assets (millions) Liabilities and Equity (millions)
Cash and interbank deposits $ 50 Core deposits $ 50
Short-term security investments 15 Large negotiable CDs 150
Total loans, gross 400 Deposits placed by brokers 65
Long-term securities 150 Other deposits 45
Other assets 10 Money market liabilities 195
Total assets $625 Other liabilities 70
Equity capital 55
Total liabilities and equity capital $625

a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by
Rhinestone. Given the mix of its assets, do you see any potential problems? What
changes would you like to see management of this bank make? Why?
b. Suppose market interest rates are projected to rise significantly. Does Rhinestone
appear to face significant losses due to liquidity risk? Due to interest rate risk? Please
be as specific as possible.

2. Kalewood Savings Bank has experienced recent changes in the composition of its
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deposits (see the following table; all figures in millions of dollars). What changes
have recently occurred in Kalewood’s deposit mix? Do these changes suggest
possible problems for management in trying to increase profitability and stabilize
earnings?

One Two Three

This Year Years Years
Year Ago Ago Ago
Types of Deposits Held
Regular and special checking accounts $235 $294 $337 $378
Interest-bearing checking accounts 392 358 329 287
Regular (passbook) savings deposits 501 596 646 709
Money market deposit accounts 863 812 749 725
Retirement deposits 650 603 542 498
CDs under $100,000 327 298 261 244
CDs $100,000 and over 606 587 522 495

3. First Metrocentre Bank posts the following schedule of fees for its household and
small-business transaction accounts:
• For average monthly account balances over $1,500, there is no monthly maintenance
fee and no charge per check or other draft.
• For average monthly account balances of $1,000 to $1,500, a $2 monthly mainte-
nance fee is assessed and there is a 10¢ charge per check or charge cleared.
• For average monthly account balances of less than $1,000, a $4 monthly maintenance
fee is assessed and there is a 15¢ per check or per charge fee.
What form of deposit pricing is this? What is First Metrocentre trying to accomplish
with its pricing schedule? Can you foresee any problems with this pricing plan?
4. Fine-Tuned Savings Association finds that it can attract the following amounts of
deposits if it offers new depositors and those rolling over their maturing CDs at the
interest rates indicated below:

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Chapter Twelve Managing and Pricing Deposit Services 421

Expected Volume Rate of Interest

of New Deposits Offered Depositors
$10 million 2.00%
15 million 2.25
20 million 2.50
24 million 2.75
26 million 3.00

Management anticipates being able to invest any new deposits raised in loans yielding
5.50 percent. How far should this thrift institution go in raising its deposit interest rate
in order to maximize total profits (excluding interest costs)?
5. New Day Bank plans to launch a new deposit campaign next week in hopes of bringing
in from $100 million to $600 million in new deposit money, which it expects to invest at
a 4.25 percent yield. Management believes that an offer rate on new deposits of 2 percent
would attract $100 million in new deposits and rollover funds. To attract $200 million, the
bank would probably be forced to offer 2.25 percent. New Day’s forecast suggests that $300
million might be available at 2.50 percent, $400 million at 2.75 percent, $500 million at
3.00 percent, and $600 million at 3.25 percent. What volume of deposits should the insti-
tution try to attract to ensure that marginal cost does not exceed marginal revenue?

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6. R&R Savings Bank finds that its basic transaction account, which requires a $1000
minimum balance, costs this savings bank an average of $3.25 per month in servicing
costs (including labor and computer time) and $1.25 per month in overhead expenses.
The savings bank also tries to build in a $0.50 per month profit margin on these
accounts. What monthly fee should the bank charge each customer?
Further analysis of customer accounts reveals that for each $100 above the $500
minimum in average balance maintained in its transaction accounts, R&R Savings
saves about 5 percent in operating expenses with each account. (Note: If the bank
saves about 5 percent in operating expenses for each $100 held in balances above the
$500 minimum, then a customer maintaining an average monthly balance of $1,000
should save the bank 25 percent in operating costs.) For a customer who consistently
maintains an average balance of $1,200 per month, how much should the bank charge
in order to protect its profit margin?
7. Lucy Lane maintains a savings deposit with Monarch Credit Union. This past year
Lucy received $10.75 in interest earnings from her savings account. Her savings
deposit had the following average balance each month:

January $450 July $450

February 350 August 425
March 300 September 550
April 550 October 600
May 225 November 625
June 400 December 500

What was the annual percentage yield (APY) earned on Lucy’s savings account?
8. The National Bank of Mayville quotes an APY of 2.75 percent on a one-year money
market CD sold to one of the small businesses in town. The firm posted a balance of
$2,500 for the first 90 days of the year, $3,000 over the next 180 days, and $3,700 for
the remainder of the year. How much in total interest earnings did this small business
customer receive for the year?

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Chapter Seventeen Lending to Business Firms and Pricing Business Loans 585

Key Terms self-liquidating loans, 552 term loans, 556 cost-plus loan pricing, 577
working capital loans, 553 revolving credit line, 556 price leadership, 578
compensating deposit project loans, 557 prime rate, 578
balances, 553 LBOs, 558 LIBOR, 580
interim construction working capital, 565 below-prime pricing, 580
loan, 554 contingent liabilities, 569 customer profitability
asset-based loans, 555 Statement of Cash analysis, 580
factoring, 555 Flows, 570
syndicated loan, 555

Problems 1. From the descriptions below please identify what type of business loan is involved.
and Projects a. A temporary credit supports construction of homes, apartments, office buildings,
and other permanent structures.
b. A loan is made to an automobile dealer to support the shipment of new cars.
c. Credit extended on the basis of a business’s accounts receivable.
d. The term of an inventory loan is being set to match the length of time needed to
generate cash to repay the loan.
e. Credit extended up to one year to purchase raw materials and cover a seasonal
need for cash.

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f. A securities dealer requires credit to add new government bonds to his securities
portfolio.
g. Credit granted for more than a year to support purchases of plant and equipment.
h. A group of investors wishes to take over a firm using mainly debt financing.
i. A business firm receives a three-year line of credit against which it can borrow,
repay, and borrow again if necessary during the loan’s term.
j. Credit extended to support the construction of a toll road.
2. As a new credit trainee for Evergreen National Bank, you have been asked to evaluate
the financial position of Hamilton Steel Castings, which has asked for renewal of and
an increase in its six-month credit line. Hamilton now requests a $7 million credit line,
and you must draft your first credit opinion for a senior credit analyst. Unfortunately,
Hamilton just changed management, and its financial report for the last six months was
not only late but also garbled. As best as you can tell, its sales, assets, operating expenses,
and liabilities for the six-month period just concluded display the following patterns:

Millions of Dollars January February March April May June

Net sales $48.1 $47.3 $45.2 $43.0 $43.9 $39.7
Cost of goods sold 27.8 28.1 27.4 26.9 27.3 26.6
Selling, administrative,
and other expenses 19.2 18.9 17.6 16.5 16.7 15.3
Depreciation 3.1 3.0 3.0 2.9 3.0 2.8
Interest cost on
borrowed funds 2.0 2.2 2.3 2.3 2.5 2.7
Expected tax obligation 1.3 1.0 0.7 0.9 0.7 0.4
Total assets 24.5 24.3 23.8 23.7 23.2 22.9
Current assets 6.4 6.1 5.5 5.4 5.0 4.8
Net fixed assets 17.2 17.4 17.5 17.6 18.0 18.0
Current liabilities 4.7 5.2 5.6 5.9 5.8 6.4
Total liabilities 15.9 16.1 16.4 16.5 17.1 17.2

Hamilton has a 16-year relationship with the bank and has routinely received and
paid off a credit line of $4 million to $5 million. The department’s senior analyst tells

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586 Part Six Providing Loans to Businesses and Consumers

you to prepare because you will be asked for your opinion of this loan request (though
you have been led to believe the loan will be approved anyway, because Hamilton’s
president serves on Evergreen’s board of directors).
What will you recommend if asked? Is there any reason to question the latest data
supplied by this customer? If this loan request is granted, what do you think the cus-
tomer will do with the funds?
3. From the data given in the following table, please construct as many of the financial
ratios discussed in this chapter as you can and then indicate what dimension of a busi-
ness firm’s performance each ratio represents.

Business Assets Annual Revenue and Expense Items

Cash account $60 Net sales $600
Accounts receivable 155 Cost of goods sold 445
Inventories 128 Wages and salaries 52
Fixed assets 286 Interest expense 28
Miscellaneous assets 96 Overhead expenses 29
725 Depreciation expenses 12
Liabilities and Equity Selling, administrative,
Short-term debt: and other expenses 28
Accounts payable 108 Before-tax net income 6
Notes payable 117* 1
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Taxes owed
Long-term debt (bonds) 325* After-tax net income 7
Miscellaneous liabilities 15
Equity capital 160
725

*Annual principal payments on bonds and notes payable total $55. The firm’s marginal tax rate is 35 percent.

4. Grape Corporation has placed a term loan request with its lender and submitted the fol-
lowing balance sheet entries for the year just concluded and the pro forma balance sheet
expected by the end of the current year. Construct a pro forma Statement of Cash Flows
for the current year using the consecutive balance sheets and some additional needed infor-
mation. The forecast net income for the current year is $210 million with $50 million
being paid out in dividends. The depreciation expense for the year will be $100 million and
planned expansions will require the acquisition of $300 million in fixed assets at the end of
the current year. As you examine the pro forma Statement of Cash Flows, do you detect any
changes that might be of concern either to the lender’s credit analyst, loan officer, or both?

Grape Corporation
(all amounts in millions of dollars)

Liabilities and
Liabilities and Equity
Assets at Assets Projected Equity at the Projected for
the End of for the End of End of the the End of
the Most the Current Most Recent the Current
Recent Year Year Year Year
Cash $ 532 $ 600 Accounts payable $ 970 $1,069
Accounts receivable 1,018 1,210 Notes payable 2,733 2,930
Inventories 894 973 Taxes payable 327 216

Net fixed assets 2,740 2,940 Long-term debt obligations 872 931
Other assets 66 87 Common stock 85 85
Undivided profits 263 373
Total assets $5,250 $5,810 Total liabilities and equity capital $5,250 $5,810

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Chapter Seventeen Lending to Business Firms and Pricing Business Loans 587

5. Blue Jay Corporation is a new business client for First Commerce National Bank and
has asked for a one-year, $10 million loan at an annual interest rate of 6 percent. The
company plans to keep a 2.75 percent, $3 million CD with the bank for the loan’s
duration. The loan officer in charge of the case recommends at least a 4 percent
annual before-tax rate of return over all costs. Using customer profitability analysis
(CPA) the loan committee hopes to estimate the following revenues and expenses
which it will project using the amount of the loan requested as a base for the calcu-
lations:

Estimated Revenues Estimated Expenses

Interest income from loan? Interest to be paid on customer’s $3 million deposit?
Loan commitment fee (0.75%)? Expected cost of additional funds needed
to support the loan (4%)?
Cash management fees (3%)? Labor costs and other operating expenses
(on an annual average of associated with monitoring
$15 million) the customer’s loan (2%)?
Cost of processing the loan (1.5%)?

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a. Should this loan be approved on the basis of the suggested terms?
b. What adjustments could be made to improve this loan’s projected return?
c. How might competition from other prospective lenders impact the adjustments
you have recommended?
6. As a loan officer for Allium National Bank, you have been responsible for the
bank’s relationship with USF Corporation, a major producer of remote-control
devices for activating television sets, DVDs, and other audio-video equipment.
USF has just filed a request for renewal of its $10 million line of credit, which will
cover approximately six months. USF also regularly uses several other services sold
by the bank. Applying customer profitability analysis (CPA) and using the most
recent year as a guide, you estimate that the expected revenues from this commer-
cial loan customer and the expected costs of serving this customer will consist of
the following:

Expected Revenues Expected Costs

Interest income from the Interest paid on customer
requested loan (assuming an deposits (2.50%) —?
annualized loan rate of 4% Cost of other funds raised 180,000
for 9 months) —? Account activity costs 5,000
Loan commitment fee (1%) 100,000 Wire transfer costs 1,300
Deposit management fees 4,500 Loan processing costs 12,400
Wire transfer fees 3,500 Recordkeeping costs 4,500
Fees for agency services 4,500

The bank’s credit analysts have estimated the customer probably will keep an average
deposit balance of $2,125,000 for the year the line is active. What is the expected net
rate of return from this proposed loan renewal if the customer actually draws down
the full amount of the requested line for six months? What decision should the bank
make under the foregoing assumptions? If you decide to turn down this request, under
what assumptions regarding revenues, expenses, and customer deposit balances would
you be willing to make this loan?

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588 Part Six Providing Loans to Businesses and Consumers

7. In order to help fund a loan request of $10 million for one year from one of its
best customers, Lone Star Bank sold negotiable CDs to its business customers in
the amount of $6 million at a promised annual yield of 2.75 percent and borrowed
$4 million in the Federal funds market from other banks at today’s prevailing interest
rate of 2.80 percent.
Credit investigation and recordkeeping costs to process this loan application were
an estimated $25,000. The Credit Analysis Division recommends a minimal 1 percent
risk premium on this loan and a minimal profit margin of one-fourth of a percentage
point. The bank prefers using cost-plus loan pricing in these cases. What loan rate
should it charge?
8. Many loans to corporations are quoted today at small risk premiums and profit mar-
gins over the London Interbank Offered Rate (LIBOR). Englewood Bank has a
$25 million loan request for working capital to fund accounts receivable and inven-
tory from one of its largest customers, APEX Exports. The bank offers its customer
a floating-rate loan for 90 days with an interest rate equal to LIBOR on 30-day
Eurodeposits (currently trading at a rate of 4 percent) plus a one-quarter percentage
point markup over LIBOR. APEX, however, wants the loan at a rate of 1.014 times
LIBOR. If the bank agrees to this loan request, what interest rate will attach to the
loan if it is made today? How does this compare with the loan rate the bank wanted to
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charge? What does this customer’s request reveal about the borrowing firm’s interest
rate forecast for the next 90 days?
9. Five weeks ago, Robin Corporation borrowed from the commercial finance company
that employs you as a loan officer. At that time, the decision was made (at your per-
sonal urging) to base the loan rate on below-prime market pricing, using the average
weekly Federal funds interest rate as the money market borrowing cost. The loan
was quoted to Robin at the Federal funds rate plus a three-eighths percentage point
markup for risk and profit.
Today, this five-week loan is due, and Robin is asking for renewal at money mar-
ket borrowing cost plus one-fourth of a point. You must assess whether the finance
company did as well on this account using the Federal funds rate as the index of
borrowing cost as it would have done by quoting Robin the prevailing CD rate, the
commercial paper rate, the Eurodollar deposit rate, or possibly the prevailing rate on
U.S. Treasury bills plus a small margin for risk and profitability. To assess what would
have happened (and might happen over the next five weeks if the loan is renewed at
a small margin over any of the money market rates listed above), you have assembled
these data from the Federal Reserve Statistical Release H15.
What conclusion do you draw from studying the behavior of these common
money market base rates for business loans? Should the Robin loan be renewed as

Weekly Averages of Money Market Rates over the Most Recent 5 Weeks
Week 1 Week 2 Week 3 Week 4 Week 5
Money Market Interest Rates (1 week ago) (5 weeks ago)
Federal funds 1.99% 2.04% 1.98% 2.06% 2.02%
Commercial paper
(one-month maturity) 2.13 2.17 2.17 2.20 2.05
CDs (one-month maturity) 2.47 2.58 2.52 2.53 2.43
Eurodollar deposits
(three-month maturity) 3.00 3.00 3.00 3.10 2.85
U.S. Treasury bills
(three-month, secondary market) 1.84 1.87 1.85 2.04 1.86

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 Confirming Pages

Chapter Eighteen Consumer Loans, Credit Cards, and Real Estate Lending 627

Problems 1. The Childress family has applied for a $5,000 loan for home improvements, espe-
cially to install a new roof and add new carpeting. Bob Childress is a welder at Ford
and Projects
Motor Co., the first year he has held that job, and his wife sells clothing at Wal-Mart.
They have three children. The Childresses own their home, which they purchased
six months ago, and have an average credit rating, with some late bill payments. They
have a telephone, but hold only a checking account with a bank and a few savings
bonds. Mr. Childress has a $35,000 life insurance policy with a cash surrender value
of $1,100. Suppose the lender uses the credit scoring system presented in this chapter
and denies all credit applications scoring fewer than 360 points. Is the Childress fam-
ily likely to get their loan? What is the family’s credit score? (Hint: For the occupa-
tion factor take the average for the husband’s and wife’s occupations.)
2. Mr. and Mrs. Napper are interested in funding their children’s college education by
taking out a home equity loan in the amount of $24,000. Eldridge National Bank
is willing to extend a loan, using the Nappers’ home as collateral. Their home has
been appraised at $110,000, and Eldridge permits a customer to use no more than
70 percent of the appraised value of a home as a borrowing base. The Nappers still
owe $60,000 on the first mortgage against their home. Is there enough residual value
left in the Nappers’ home to support their loan request? How could the lender help
them meet their credit needs?

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3. Greg Lance has just been informed by a finance company that he can access a line of
credit of no more than $75,000 based upon the equity value in his home. Lance still
owes $180,000 on a first mortgage against his home and $25,000 on a second mort-
gage against the home, which was incurred last year to repair the roof and driveway.
If the appraised value of Lance’s residence is $400,000, what percentage of the home’s
estimated market value is the lender using to determine James’s maximum available
line of credit?
4. What term in the consumer lending field does each of the following statements
describe?
a. Plastic card used to pay for goods and services without borrowing money.
b. Loan to purchase an automobile and pay it off monthly.
c. If you fail to pay the lender seizes your deposit.
d. Numerical rating describing likelihood of loan repayment.
e. Loans extended to low-credit-rated borrowers.
f. Loan based on spread between a home’s market value and its mortgage balance.
g. Method for calculating rebate borrower receives from retiring a loan early.
h. Lender requires excessive insurance fees on a new loan.
i. Loan rate lenders must quote under the Truth in Lending Act.
j. Upfront payment required as a condition for getting a home loan.
5. Which federal law or laws apply to each of the situations described below?
a. A loan officer asks an individual requesting a loan about her race.
b. A bill collector called Jim Jones three times yesterday at his work number without
first asking permission.
c. Sixton National Bank has developed a special form to tell its customers the finance
charges they must pay to secure a loan.
d. Consumer Savings Bank has just received an outstanding rating from federal
examiners for its efforts to serve all segments of its community.
e. Presage State Bank must disclose once a year the areas in the local community
where it has made home mortgage and home improvement loans.

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628 Part Six Providing Loans to Businesses and Consumers

f. Reliance Credit Card Company is contacted by one of its customers in a dispute

over the amount of charges the customer made at a local department store.
g. Amy Imed, after requesting a copy of her credit report, discovers several errors and
demands a correction.
6. James Smithern has asked for a $3,500 loan from Beard Center National Bank to
repay some personal expenses. The bank uses a credit-scoring system to evaluate such
requests, which contains the following discriminating factors along with their associ-
ated point weights in parentheses:
Credit Rating (excellent, 3; average, 2; poor or no record, 0)
Time in Current Job (five years or more, 6; one to five years, 3)
Time at Current Residence (more than 2 years, 4; one to two years, 2; less than one
year, 1)
Telephone in Residence (yes, 1; no, 0)
Holds Account at Bank (yes, 2; no, 0)
The bank generally grants a loan if a customer scores 9 or more points. Mr. Smithern
has an average credit rating, has been in his current job for three years and at his cur-
rent residence for two years, has a telephone, but has no account at the bank. Is James
Smithern likely to receive the loan he has requested?
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7. Yorktown Savings Bank, in reviewing its credit card customers, finds that of those
customers who scored 40 points or less on its credit-scoring system, 30 percent (or a
total of 7,665 credit customers) turned out to be delinquent credits, resulting in total
loss. This group of bad credit card loans averaged $6,200 in size per customer account.
Examining its successful credit accounts Yorktown finds that 12 percent of its good
customers (or a total of 3,066 customers) scored 40 points or less on the bank’s scor-
ing system. These low-scoring but good accounts generated about $1,000 in revenues
each. If Yorktown’s credit card division follows the decision rule of granting credit
cards only to those customers scoring more than 40 points and future credit accounts
generate about the same average revenues and losses, about how much can the bank
expect to save in net losses?
8. The Lathrop family needs some extra funds to put their two children through college
starting this coming fall and to buy a new computer system for a part-time home busi-
ness. They are not sure of the current market value of their home, though comparable
four-bedroom homes are selling for about $395,000 in the neighborhood. The Mon-
arch University Credit Union will loan 75 percent of the property’s appraised value,
but the Lathrops still owe $235,000 on their home mortgage and a home improve-
ment loan combined. What maximum amount of credit is available to this family
should it elect to seek a home equity credit line?
9. San Carlos Bank and Trust Company uses a credit-scoring system to evaluate most
consumer loans that amount to more than $2,500. The key factors used in its scoring
system are found at the conclusion of this problem.
The Mulvaney family has two wage earners who have held their present jobs for
18 months. They have lived at their current street address for one year, where
they rent on a six-month lease. Their credit report is excellent but shows only
one previous charge. However, they are actively using two credit cards right now
to help with household expenses. Yesterday, they opened an account at San Car-
los and deposited $250. The Mulvaneys have asked for a $4,500 loan to purchase
a used car and some furniture. The bank has a cutoff score in its scoring system
of 30 points. Would you make this loan for two years, as they have requested?

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 Chapter Eighteen Consumer Loans, Credit Cards, and Real Estate Lending 629

Are there factors not included in the scoring system that you would like to know
more about? Please explain.

Borrower’s length of employment in his/her Credit bureau report:

present job: Excellent 8 points
More than one year 6 points Average 5 points
Less than one year 3 points Below average or no record 2 points
Borrower’s length of time at current address: Credit cards currently active:
More than 2 years 8 points One card 6 points
One to two years 4 points Two cards 4 points
Less than one year 2 points More than two cards 2 points
Borrower’s current home situation: Deposit account(s) with bank:
Owns home 7 points Yes 5 points
Rents home or apartment 4 points No 2 points
Lives with friend or relative 2 points

10. Clyde Cook wants to start his own business. He has asked his bank for a $50,000
new-venture loan. The bank has a policy of making discount-rate loans in these cases
if the venture looks good, but at an interest rate of prime plus 2. (The prime rate is
currently posted at 4.25 percent.) If Mr. Cook’s loan is approved for the full amount

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requested, what net proceeds will he have to work with from this loan? What is the
effective interest rate on this loan for one year?
11. The Michael family has asked for a 30-year mortgage in the amount of $325,000 to
purchase a home. At a 5.25 percent loan rate, what is the required monthly payment?
12. Barb Jones received a $5,000 loan last month with the intention of repaying the loan
in 12 months. However, Jones now discovers she has cash to repay the loan after mak-
ing just three payments. What percentage of the total finance charge is Jones entitled
to receive as a rebate and what percentage of the loan’s finance charge is the lender
entitled to keep?
13. The Bender family has been planning a vacation to Europe for the past two years.
Tabb Savings agrees to advance a loan of $8,000 to finance the trip provided the
Benders pay the loan back in 12 equal monthly installments. Tabb will charge an add-
on loan rate of 5.75 percent. How much in interest will the Benders pay under the
add-on rate method? What is the amount of each required monthly payment? What
is the effective loan rate in this case?
14. Jane Zahrley’s request for a four-year automobile loan for $39,000 has been approved.
Reston Bank will require equal monthly installment payments for 60 months. The
bank tells Jane that she must pay a total of $5,500 in finance charges. What is the
loan’s APR?
15. Susie Que has asked for a 25-year mortgage to purchase a home at Nag’s Head. The
purchase price is $465,000, of which Susie must borrow $395,000 to be repaid in
monthly installments. If Susie can get this loan for an APR of 5.50 percent, how
much in total finance charges must she pay?
16. Mary Contrary is offered a $1,600 loan for a year to be paid back in equal quarterly
principal installments of $400 each. If Mary is offered the loan at 6 percent simple
interest, how much in total interest charges will she pay? Would Mary be better off
(in terms of lower interest cost) if she were offered the $1,600 at 5 percent simple
interest with only one principal payment when the loan reaches maturity? What
advantage would this second set of loan terms have over the first set of loan terms?
 Confirming Pages

630 Part Six Providing Loans to Businesses and Consumers

17. Buck and Marie Rogers are negotiating with their local bank to secure a mortgage loan
in order to buy their first home. With only a limited down payment available to them,
Buck and Marie must borrow $300,000. Moreover, the bank has assessed them a half
point on the loan. What is the dollar amount of points they must pay to receive this
loan? How much home mortgage credit will they actually have available for their use?
18. Dryden Bank’s personal loan department quotes Lance Greg a finance charge of
$3.75 for each $100 in credit the bank is willing to extend to him for a year (assuming
the balance of the loan is to be paid off in 12 equal installments). What APR is the
bank quoting Lance? How much would he save per $100 borrowed if he could retire
the loan in six months?
Internet Exercises
1. What is credit scoring? Visit www.myfico.com and click on the “Education” button.
You will find a link—“What’s in your FICO score”.
2. How does the Web help a consumer loan officer determine a customer’s credit rat-
ing and credit history? For an example, go to www.experian.com and see Enter-
prise Services. What products and services does this firm have to offer a credit
union?
3. Go to www.mortgage101.com/morgage-library/31 to find the meaning of such real
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estate lending terms as adjustable-rate mortgage, subprime loans, and home equity loans.
Provide the definition for each of the above terms.
4. What methods and tools are available on the Web to aid in pricing consumer loans
and real estate credit? See, for example, www.financialpowertools.com. Use the auto
loan calculator to calculate the monthly payments on a 48-month car loan given
that the purchase price is $23,000; the down payment is $1,200; the trade-in value of
the customer’s current vehicle is $5,000, but $4,000 is still owed; nontaxable fees are
$40.00, sales tax is 7 percent, and the interest rate is 5 percent.
5. Why is regulation so important in the personal loan area? For some insights regarding
this issue, visit www.hud.gov and www.ffiec.gov. At www.hud.gov/offices/hsg/sfh/pred/
predlend.cfm find the meaning of and concerns associated with predatory lending. At
www.ffiec.gov determine the purpose of the Home Mortgage Disclosure Act (HMDA).

REAL NUMBERS Continuing Case Assignment for Chapter 18

FOR REAL BANKS

YOUR BANK’S PROVISION OF CREDIT TO Retail loans were allocated either to the real estate loan
INDIVIDUALS AND FAMILIES category or to the loans to individuals category. In this
Chapter 18 explores consumer loans, credit cards, and real assignment we will go back to the SDI at www2.fdic.gov/
estate lending. In this assignment we look at how regulators sdi/ and collect more detailed information on these loans.
categorize loans to individuals and families. We will use this This entails using SDI to create a four-column report of your
information to evaluate the changing composition of your bank’s information and peer group information across years.
bank’s retail loan portfolio across years and relative to other For Report Selection, you will access the Net Loans and
large banks. Leases and 1–4 Family Residential Net Loans and Leases
reports to collect percentage information as detailed below.
Trend and Comparative Analysis Enter this data into the spreadsheet used for comparisons
A. Data Collection: In the assignment for Chapter 16, we did with the peer group as illustrated for BB&T:
a breakdown of gross loans and leases based on purpose.

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248 Part Three Tools For Managing and Hedging against Risk

• More recently, many financial firms have practiced funds management, discovering how
to coordinate the management of both assets and liabilities in order to achieve institu-
tional goals.
• One of the strongest risk factors financial-service managers have to deal with every
day is interest rate risk. Managers cannot control market interest rates, but instead
they must learn how to react to interest rate changes in order to control their risk
exposure.
• One of the most popular tools for handling interest rate risk exposure is interest-
sensitive gap management, which focuses upon protecting or maximizing each finan-
cial firm’s net interest margin or spread between interest revenues and interest costs.
Managers determine for any given time period whether their institution is asset
sensitive (with an excess of interest rate–sensitive assets) or liability sensitive (with
more rate-sensitive liabilities than rate-sensitive assets). These interest-sensitive
gaps are then compared with the financial firm’s interest rate forecast, and manage-
ment takes appropriate action.
• Managers soon discovered that interest-sensitive gap management didn’t necessarily
protect a financial firm’s net worth—value of shareholders’ investment in the institu-
tion. This job required the development of duration gap management.
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• Based on the concept of duration—a value- and time-weighted measure of maturity—

the managers of financial institutions learned how to assess their exposure to loss in net
worth from relative changes in the value of assets and liabilities when market interest
rates change. This technique points to the importance of avoiding large gaps between
average asset duration and average liability duration.

Key Terms asset-liability yield to maturity duration gap

management, 218 (YTM), 221 management, 236
asset management, 218 bank discount rate, 222 duration, 237
liability maturity gap, 225 convexity, 239
management, 218 net interest margin, 226 duration gap, 239
funds management, 219 interest-sensitive gap portfolio
interest rate risk, 219 management, 226 immunization, 246

1195 = 75/(1+r) + .... + 1075/(1+r)^14

Problems 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
and Projects
its yield to maturity if purchased today for $1,195?
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? 1195 = 75/(1+r) +... + 75/(1+r)^5 + 940/(1+r)^5
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 a. DR = (100-97.25)/100 x 360/182 = 0.054
b. $95.75, 270 days YTM = (100-97.25)/97.25 x 365/182 = 0.057
b. DR = (100-95.75)/100 x 360/270 = 0.056
c. $98.75, 91 days YTM = (100-95.75)/95.75 x 365/270 = 0.06
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?

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Chapter Seven Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques 249

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 interest costs and earning assets increase
9 percent. What will happen to Farmville’s net interest margin?
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
NII = NIM x total assets
= 2.5% x 1.1 x 575 x 1.2 = 18.975 change will occur in the bank’s net interest income?
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
Change in NII =
level of 3 percent, what changes will occur in this thrift’s net interest income?
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 $ 82.00 $ 80.00 $ 78.00
Interest expenses 64.00 66.00 68.00
Loans (excluding nonperforming) 450.00 425.00 400.00
Investments 200.00 195.00 200.00

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Total deposits 450.00 425.00 400.00
Money market borrowings 150.00 125.00 100.00

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?
8. The First National Bank of Dogsville finds that its asset and liability portfolio con-
tains 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 accounts 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?
9. Sunset Savings Bank currently has the following interest-sensitive assets and liabili-
ties 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

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250 Part Three Tools For Managing and Hedging against Risk

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?
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 sensi-
tive? Under what scenario for market interest rates will Sparkle experience a gain in
net interest income? A loss in net interest income?
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

Principal and Interest Payments Receipts Are Expected
$1,275,600 Current year
746,872 Two years from today
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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 Payments Must Be Made
$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 Snowman’s portfolio of earning assets and of its deposits and money mar-
ket borrowings? What will happen to the bank’s total returns, assuming all other fac-
tors 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.
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 Snow-
man’s net worth in this case and by how much in dollars does it change? What is the
size of its duration gap?
13. Conway Thrift Association reports an average asset duration of 7 years and an aver-
age 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

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Chapter Seven Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques 251

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?
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 experi-
ence if market interest rates change as anticipated?
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?
16. Blue Moon National Bank holds assets and liabilities whose average durations and
dollar amounts are as shown in this table:

Asset and Liability Items Avg. Duration (years) Dollar Amount (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

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Nondeposit borrowings 0.50 50.00

What is the weighted-average duration of Blue Moon’s asset portfolio and liability
portfolio? What is its leverage-adjusted duration gap?
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?
18. Carter National Bank holds $15 million in government bonds having a duration of
12 years. If interest rates suddenly rise from 6 percent to 7 percent, what percentage
change should occur in the bonds’ market price?

Internet Exercises
1. At www.almprofessional.com you will find a network devoted to articles and discus-
sions of the asset-liability management field. Visit the site and find an article entitled
“Principles for the Management of Interest Rate Risk.” What are the major sources of
interest rate risk according to this article?
2. If you would like to view the current yield curve go to www.bloomberg.com/markets/
rates/index.html. What are the current yields on 3-month Ttreasury bills, 5-year Trea-
sury notes, and 30-year Ttreasury bonds? Describe the shape of the yield curve.
3. If you want to learn more about duration, go to www.bionicturtle.com/how-to/
article/modified-vs-macaulay-duration/ and read through this How-To learning seg-
ment. Define modified duration, and describe why it is useful.
4. See if you can find the meaning of modified duration on the Web. Where did you find
it, and what did you find? (Hint: Try the website in Internet Exercise 3.)
5. Duration gap management is a powerful analytical tool for protecting net worth of a
financial institution from damage due to shifting interest rates. Asset-liability manag-
ers have found this tool surprisingly resilient and robust even when its basic assump-
tions are not fully met. Go to www.ots.treas.gov/docs/4/422196.pdf, and see how
bank regulators in the U.S. Treasury understand duration gaps.

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