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Chapter One

Why Are Financial Intermediaries Special?


Chapter Outline

Introduction

Financial Intermediaries Specialness


Information Costs
Liquidity and Price Risk
Other Special Services

Other Aspects of Specialness


The Transmission of Monetary Policy
Credit Allocation
Intergenerational Wealth Transfers or Time Intermediation
Payment Services
Denomination Intermediation

Specialness and Regulation


Safety and Soundness Regulation
Monetary Policy Regulation
Credit Allocation Regulation
Consumer Protection Regulation
Investor Protection Regulation
Entry Regulation

The Changing Dynamics of Specialness


Trends in the United States
Future Trends
Global Issues

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter One

1. Identify and briefly explain the five risks common to financial institutions.

Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets
and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks.

2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without financial intermediaries (FIs).

In a world without FIs the users of corporate funds in the economy would have to approach
directly the household savers of funds in order to satisfy their borrowing needs. This process
would be extremely costly because of the up-front information costs faced by potential lenders.
Cost inefficiencies would arise with the identification of potential borrowers, the pooling of
small savings into loans of sufficient size to finance corporate activities, and the assessment of
risk and investment opportunities. Moreover, lenders would have to monitor the activities of
borrowers over each loan's life span. The net result would be an imperfect allocation of resources
in an economy.

3. Identify and explain three economic disincentives that probably would dampen the flow of
funds between household savers of funds and corporate users of funds in an economic
world without financial intermediaries.

Investors generally are averse to purchasing securities directly because of (a) monitoring costs,
(b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive
time, expense, and expertise. As a result, households would prefer to leave this activity to
others, and by definition, the resulting lack of monitoring would increase the riskiness of
investing in corporate debt and equity markets. The long-term nature of corporate equity and
debt would likely eliminate at least a portion of those households willing to lend money, as the
preference of many for near-cash liquidity would dominate the extra returns which may be
available. Third, the price risk of transactions on the secondary markets would increase without
the information flows and services generated by high volume.

4. Identify and explain the two functions in which FIs may specialize that enable the smooth
flow of funds from household savers to corporate users.

FIs serve as conduits between users and savers of funds by providing a brokerage function and
by engaging in the asset transformation function. The brokerage function can benefit both savers
and users of funds and can vary according to the firm. FIs may provide only transaction services,
such as discount brokerages, or they also may offer advisory services which help reduce
information costs, such as full-line firms like Merrill Lynch. The asset transformation function is
accomplished by issuing their own securities, such as deposits and insurance policies that are
more attractive to household savers, and using the proceeds to purchase the primary securities of
corporations. Thus, FIs take on the costs associated with the purchase of securities.

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5. In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives, to
the savers?

The funds raised by the financial claims issued by commercial corporations are used to invest in
real assets. These financial claims, which are considered primary securities, are purchased by
FIs whose financial claims therefore are considered secondary securities. Savers who invest in
the financial claims of FIs are indirectly investing in the primary securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring
expenses, liquidity costs, and price risk of placing the investments directly with the commercial
corporation are reduced because of the efficiencies of the FI.

6. Explain how financial institutions act as delegated monitors. What secondary benefits
often accrue to the entire financial system because of this monitoring process?

By putting excess funds into financial institutions, individual investors give to the FIs the
responsibility of deciding who should receive the money and of ensuring that the money is
utilized properly by the borrower. In this sense the depositors have delegated the FI to act as a
monitor on their behalf. The FI can collect information more efficiently than individual
investors. Further, the FI can utilize this information to create new products, such as commercial
loans, that continually update the information pool. This more frequent monitoring process
sends important informational signals to other participants in the market, a process that reduces
information imperfection and asymmetry between the ultimate sources and users of funds in the
economy.

7. What are five general areas of FI specialness that are caused by providing various services
to sectors of the economy?

First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price-risk conditions than primary securities. Fourth,
FIs provide economies of scale in transaction costs because assets are purchased in larger
amounts. Finally, FIs provide maturity intermediation to the economy which allows the
introduction of additional types of investment contracts, such as mortgage loans, that are
financed with short-term deposits.

8. How do FIs solve the information and related agency costs when household savers invest
directly in securities issued by corporations? What are agency costs?

Agency costs occur when owners or managers take actions that are not in the best interests of the
equity investor or lender. These costs typically result from the failure to adequately monitor the
activities of the borrower. If no other lender performs these tasks, the lender is subject to agency
costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests
the funds of many small savers, the FI has a greater incentive to collect information and monitor
the activities of the borrower.

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9. What often is the benefit to the lenders, borrowers, and financial markets in general of the
solution to the information problem provided by the large financial institutions?

One benefit to the solution process is the development of new secondary securities that allow
even further improvements in the monitoring process. An example is the bank loan that is
renewed more quickly than long-term debt. The renewal process updates the financial and
operating information of the firm more frequently, thereby reducing the need for restrictive bond
covenants that may be difficult and costly to implement.

10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in
the securities of corporations?

Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial
banks, for example, offer deposits that can be withdrawn at any time. Yet the banks make long-
term loans or invest in illiquid assets because they are able to diversify their portfolios and better
monitor the performance of firms that have borrowed or issued securities. Thus individual
investors are able to realize the benefits of investing in primary assets without accepting the
liquidity risk of direct investment.

11. How do financial institutions help individual savers diversify their portfolio risks? Which
type of financial institution is best able to achieve this goal?

Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government customers,
and insurance companies have investments in many different types of assets. Investment in a
mutual fund may generate the greatest diversification benefit because of the funds investment in
a wide array of stocks and fixed income securities.

12. How can financial institutions invest in high-risk assets with funding provided by low-risk
liabilities from savers?

Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an
FI will be less than the average risk of the individual assets in which it has invested. Thus
individual investors realize some of the returns of high-risk assets without accepting the
corresponding risk characteristics.

13. How can individual savers use financial institutions to reduce the transaction costs of
investing in financial assets?

By pooling the assets of many small investors, FIs can gain economies of scale in transaction
costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or
purchasing assets in the money and capital markets. In either case, operating activities that are
designed to deal in large volumes typically are more efficient than those activities designed for
small volumes.

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14. What is maturity intermediation? What are some of the ways in which the risks of maturity
intermediation are managed by financial intermediaries?

If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by matching their asset and liability maturities through on- and off-balance sheet hedging
activities and flexible access to the financial markets. For example, the FI can offer the
relatively short-term liabilities desired by households and also satisfy the demand for long-term
loans such as home mortgages. By investing in a portfolio of long-and short-term assets that
have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing
liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options,
swaps, and other derivative products.

15. What are five areas of institution-specific FI specialness, and which types of institutions are
most likely to be the service providers?

First, commercial banks and other depository institutions are key players for the transmission of
monetary policy from the central bank to the rest of the economy. Second, specific FIs often are
identified as the major source of finance for certain sectors of the economy. For example, S&Ls
and savings banks traditionally serve the credit needs of the residential real estate market. Third,
life insurance and pension funds commonly are encouraged to provide mechanisms to transfer
wealth across generations. Fourth, depository institutions efficiently provide payment services to
benefit the economy. Finally, mutual funds provide denomination intermediation by allowing
small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs
and commercial paper issues.

16. How do depository institutions such as commercial banks assist in the implementation and
transmission of monetary policy?

The Federal Reserve Board can involve directly the commercial banks in the implementation of
monetary policy through changes in the reserve requirements and the discount rate. The open
market sale and purchase of Treasury securities by the Fed involves the banks in the
implementation of monetary policy in a less direct manner.

17. What is meant by credit allocation regulation? What social benefit is this type of regulation
intended to provide?

Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the
economy, which are considered to be socially important. These may include housing and
farming. Presumably the provision of credit to make houses more affordable or farms more
viable leads to a more stable and productive society.

18. Which intermediaries best fulfill the intergenerational wealth transfer function? What is
this wealth transfer process?

Life insurance and pension funds often receive special taxation relief and other subsidies to assist
in the transfer of wealth from one generation to another. In effect, the wealth transfer process

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allows the accumulation of wealth by one generation to be transferred directly to one or more
younger generations by establishing life insurance policies and trust provisions in pension plans.
Often this wealth transfer process avoids the full marginal tax treatment that a direct payment
would incur.

19. What are two of the most important payment services provided by financial institutions?
To what extent do these services efficiently provide benefits to the economy?

The two most important payment services are check clearing and wire transfer services. Any
breakdown in these systems would produce gridlock in the payment system with resulting
harmful effects to the economy at both the domestic and potentially the international level.

20. What is denomination intermediation? How do FIs assist in this process?

Denomination intermediation is the process whereby small investors are able to purchase pieces
of assets that normally are sold only in large denominations. Individual savers often invest small
amounts in mutual funds. The mutual funds pool these small amounts and purchase negotiable
CDs which can only be sold in minimum increments of $100,000, but which often are sold in
million dollar packages. Similarly, commercial paper often is sold only in minimum amounts of
$250,000. Therefore small investors can benefit in the returns and low risk which these assets
typically offer.

21. What is negative externality? In what ways do the existence of negative externalities justify
the extra regulatory attention received by financial institutions?

A negative externality refers to the action by one party that has an adverse affect on some third
party who is not part of the original transaction. For example, in an industrial setting, smoke
from a factory that lowers surrounding property values may be viewed as a negative externality.
For financial institutions, one concern is the contagion effect that can arise when the failure of
one FI can cast doubt on the solvency of other institutions in that industry.

22. If financial markets operated perfectly and costlessly, would there be a need for financial
intermediaries?

To a certain extent, financial intermediation exists because of financial market imperfections. If


information is available costlessly to all participants, savers would not need intermediaries to act
as either their brokers or their delegated monitors. However, if there are social benefits to
intermediation, such as the transmission of monetary policy or credit allocation, then FIs would
exist even in the absence of financial market imperfections.

23. What is mortgage redlining?

Mortgage redlining occurs when a lender specifically defines a geographic area in which it
refuses to make any loans. The term arose because of the area often was outlined on a map with
a red pencil.

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24. Why are FIs among the most regulated sectors in the world? When is net regulatory
burden positive?

FIs are required to enhance the efficient operation of the economy. Successful financial
intermediaries provide sources of financing that fund economic growth opportunity that
ultimately raises the overall level of economic activity. Moreover, successful financial
intermediaries provide transaction services to the economy that facilitate trade and wealth
accumulation.

Conversely, distressed FIs create negative externalities for the entire economy. That is, the
adverse impact of an FI failure is greater than just the loss to shareholders and other private
claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs
also may be thrown into financial distress by a contagion effect. Therefore, since some of the
costs of the failure of an FI are generally borne by society at large, the government intervenes in
the management of these institutions to protect society's interests. This intervention takes the
form of regulation.

However, the need for regulation to minimize social costs may impose private costs to the firms
that would not exist without regulation. This additional private cost is defined as a net regulatory
burden. Examples include the cost of holding excess capital and/or excess reserves and the extra
costs of providing information. Although they may be socially beneficial, these costs add to
private operating costs. To the extent that these additional costs help to avoid negative
externalities and to ensure the smooth and efficient operation of the economy, the net regulatory
burden is positive.

25. What forms of protection and regulation do regulators of FIs impose to ensure their safety
and soundness?

Regulators have issued several guidelines to insure the safety and soundness of FIs:

a. FIs are required to diversify their assets. For example, banks cannot lend more than 10
percent of their equity to a single borrower.
b. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.
In the case of banks, the Basle standards require a minimum core and supplementary
capital of 8 percent of their risk-adjusted assets.
c. Regulators have set up guaranty funds such as BIF for commercial banks, SIPC for
securities firms, and state guaranty funds for insurance firms to protect individual investors.
d. Regulators also engage in periodic monitoring and surveillance, such as on-site
examinations, and request periodic information from the FIs.

26. In the transmission of monetary policy, what is the difference between inside money and
outside money? How does the Federal Reserve Board try to control the amount of inside
money? How can this regulatory position create a cost for the depository financial
institutions?

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Outside money is that part of the money supply directly produced and controlled by the Fed, for
example, coins and currency. Inside money refers to bank deposits not directly controlled by the
Fed. The Fed can influence this amount of money by reserve requirement and discount rate
policies. In cases where the level of required reserves exceeds the level considered optimal by
the FI, the inability to use the excess reserves to generate revenue may be considered a tax or
cost of providing intermediation.

27. What are some examples of credit allocation regulation? How can this attempt to create
social benefits create costs to the private institution?

The qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their assets in
residential mortgage-related assets to retain the thrift charter. Some states have enacted usury
laws that place maximum restrictions on the interest rates that can be charged on mortgages
and/or consumer loans. These types of restrictions often create additional operating costs to the
FI and almost certainly reduce the amount of profit that could be realized without such
regulation.

28. What is the purpose of the Home Mortgage Disclosure Act? What are the social benefits
desired from the legislation? How does the implementation of this legislation create a net
regulatory burden on financial institutions?

The HMDA was passed by Congress to prevent discrimination in mortgage lending. The social
benefit is to ensure that everyone who qualifies financially is provided the opportunity to
purchase a house should they so desire. The regulatory burden has been to require a written
statement indicating the reasons why credit was or was not granted. Since 1990, the federal
regulators have examined millions of mortgage transactions from more than 7,700 institutions
each calendar quarter.

29. What legislation has been passed specifically to protect investors who use investment
banks directly or indirectly to purchase securities? Give some examples of the types of
abuses for which protection is provided.

The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by
Congress to protect investors against possible abuses such as insider trading, lack of disclosure,
outright malfeasance, and breach of fiduciary responsibilities.

30. How do regulations regarding barriers to entry and the scope of permitted activities affect
the charter value of financial institutions?

The profitability of existing firms will be increased as the direct and indirect costs of establishing
competition increase. Direct costs include the actual physical and financial costs of establishing
a business. In the case of FIs, the financial costs include raising the necessary minimum capital
to receive a charter. Indirect costs include permission from regulatory authorities to receive a
charter. Again in the case of FIs this cost involves acceptable leadership to the regulators. As
these barriers to entry are stronger, the charter value for existing firms will be higher.

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31. What reasons have been given for the growth of investment companies at the expense of
traditional banks and insurance companies?

The recent growth of investment companies can be attributed to two major factors:

a. Investors have demanded increased access to direct securities markets. Investment


companies and pension funds allow investors to take positions in direct securities markets
while still obtaining the risk diversification, monitoring, and transactional efficiency
benefits of financial intermediation. Some experts would argue that this growth is the
result of increased sophistication on the part of investors; others would argue that the
ability to use these markets has caused the increased investor awareness. The growth in
these assets is inarguable.

b. Recent episodes of financial distress in both the banking and insurance industries have led
to an increase in regulation and governmental oversight, thereby increasing the net
regulatory burden of traditional companies. As such, the costs of intermediation have
increased, which increases the cost of providing services to customers.

32. What are some of the methods which banking organizations have employed to reduce the
net regulatory burden? What has been the effect on profitability?

Through regulatory changes, FIs have begun changing the mix of business products offered to
individual users and providers of funds. For example, banks have acquired mutual funds, have
expanded their asset and pension fund management businesses, and have increased the security
underwriting activities. In addition, legislation that allows banks to establish branches anywhere
in the United States has caused a wave of mergers. As the size of banks has grown, an expansion
of possible product offerings has created the potential for lower service costs. Finally, the
emphasis in recent years has been on products that generate increases in fee income, and the
entire banking industry has benefited from increased profitability in recent years.

33. What characteristics of financial products are necessary for financial markets to become
efficient alternatives to financial intermediaries? Can you give some examples of the
commoditization of products which were previously the sole property of financial
institutions?

Financial markets can replace FIs in the delivery of products that (1) have standardized terms, (2)
serve a large number of customers, and (3) are sufficiently understood for investors to be
comfortable in assessing their prices. When these three characteristics are met, the products
often can be treated as commodities. One example of this process is the migration of over-the-
counter options to the publicly traded option markets as trading volume grows and trading terms
become standardized.

34. In what way has Regulation 144A of the Securities and Exchange Commission provided an
incentive to the process of financial disintermediation?

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Changing technology and a reduction in information costs are rapidly changing the nature of
financial transactions, enabling savers to access issuers of securities directly. Section 144A of the
SEC is a recent regulatory change that will facilitate the process of disintermediation. The
private placement of bonds and equities directly by the issuing firm is an example of a product
that historically has been the domain of investment bankers. Although historically private
placement assets had restrictions against trading, regulators have given permission for these
assets to trade among large investors who have assets of more than $100 million. As the market
grows, this minimum asset size restriction may be reduced.

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Chapter Two
The Financial Services Industry: Depository Institutions
Chapter Outline

Introduction

Commercial Banks
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Other Fee-Generating Activities
Regulation
Industry Performance

Savings Institutions
Savings Associations (SAs)
Savings Banks
Recent Performance of Savings Associations and Savings Banks

Credit Unions
Size, Structure, and Composition of the Industry and Recent Trends
Balance Sheets
Regulation
Industry Performance

Global Issues: Japan, China, and Germany

Summary

Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) Framework

Appendix 2B: Depository Institutions and Their Regulators

Appendix 3B: Technology in Commercial Banking

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Solutions for End-of-Chapter Questions and Problems: Chapter Two

1. What are the differences between community banks, regional banks, and money-center
banks? Contrast the business activities, location, and markets of each of these bank groups.

Community banks typically have assets under $1 billion and serve consumer and small business
customers in local markets. In 2003, 94.5 percent of the banks in the United States were
classified as community banks. However, these banks held only 14.6 percent of the assets of the
banking industry. In comparison with regional and money-center banks, community banks
typically hold a larger percentage of assets in consumer and real estate loans and a smaller
percentage of assets in commercial and industrial loans. These banks also rely more heavily on
local deposits and less heavily on borrowed and international funds.

Regional banks range in size from several billion dollars to several hundred billion dollars in
assets. The banks normally are headquartered in larger regional cities and often have offices and
branches in locations throughout large portions of the United States. Although these banks
provide lending products to large corporate customers, many of the regional banks have
developed sophisticated electronic and branching services to consumer and residential
customers. Regional banks utilize retail deposit bases for funding, but also develop relationships
with large corporate customers and international money centers.

Money center banks rely heavily on nondeposit or borrowed sources of funds. Some of these
banks have no retail branch systems, and most regional banks are major participants in foreign
currency markets. These banks compete with the larger regional banks for large commercial
loans and with international banks for international commercial loans. Most money center banks
have headquarters in New York City.

2. Use the data in Table 2-4 for the banks in the two asset size groups (a) $100 million-$1
billion and (b) over $10 billion to answer the following questions.

a. Why have the ratios for ROA and ROE tended to increase for both groups over the
1990-2003 period? Identify and discuss the primary variables that affect ROA and
ROE as they relate to these two size groups.

The primary reason for the improvements in ROA and ROE in the late 1990s may be
related to the continued strength of the macroeconomy that allowed banks to operate with a
reduced regard for bad debts, or loan charge-off problems. In addition, the continued low
interest rate environment has provided relatively low-cost sources of funds, and a shift
toward growth in fee income has provided additional sources of revenue in many product
lines. Finally, a growing secondary market for loans has allowed banks to control the size
of the balance sheet by securitizing many assets. You will note some variance in
performance in the last three years as the effects of a softer economy were felt in the
financial industry.

b. Why is ROA for the smaller banks generally larger than ROA for the large banks?

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Small banks historically have benefited from a larger spread between the cost rate of funds
and the earning rate on assets, each of which is caused by the less severe competition in the
localized markets. In addition, small banks have been able to control credit risk more
efficiently and to operate with less overhead expense than large banks.

c. Why is the ratio for ROE consistently larger for the large bank group?

ROE is defined as net income divided by total equity, or ROA times the ratio of assets to
equity. Because large banks typically operate with less equity per dollar of assets, net
income per dollar of equity is larger.

d. Using the information on ROE decomposition in Appendix 2A, calculate the ratio of
equity-to-total-assets for each of the two bank groups for the period 1990-2003. Why
has there been such dramatic change in the values over this time period, and why is
there a difference in the size of the ratio for the two groups?

ROE = ROA x (Total Assets/Equity)


Therefore, (Equity/Total Assets) = ROA/ROE

$100 million - $1 Billion Over $10 Billion


Year ROE ROA TA/Equity Equity/TA ROE ROA TA/Equity Equity/TA
1990 9.95% 0.78% 12.76 7.84% 6.68% 0.38% 17.58 5.69%
1995 13.48% 1.25% 10.78 9.27% 15.60% 1.10% 14.18 7.05%
1996 13.63% 1.29% 10.57 9.46% 14.93% 1.10% 13.57 7.37%
1997 14.50% 1.39% 10.43 9.59% 15.32% 1.18% 12.98 7.70%
1998 13.57% 1.31% 10.36 9.65% 13.82% 1.08% 12.80 7.81%
1999 14.24% 1.34% 10.63 9.41% 15.97% 1.28% 12.48 8.02%
2000 13.56% 1.28% 10.59 9.44% 14.42% 1.16% 12.43 8.04%
2001 12.24% 1.20% 10.20 9.80% 13.43% 1.13% 11.88 8.41%
2002 12.85% 1.26% 10.20 9.81% 15.06% 1.32% 11.41 8.76%
2003 12.80% 1.27% 10.08 9.92% 16.32% 1.42% 11.49 8.70%

The growth in the equity to total assets ratio has occurred primarily because of the
increased profitability of the entire banking industry and the encouragement of the
regulators to increase the amount of equity financing in the banks. Increased fee income,
reduced loan loss reserves, and a low, stable interest rate environment have produced the
increased profitability which in turn has allowed banks to increase equity through retained
earnings.

Smaller banks tend to have a higher equity ratio because they have more limited asset
growth opportunities, generally have less diverse sources of funds, and historically have
had greater profitability than larger banks.

3. What factors have caused the decrease in loan volume relative to other assets on the
balance sheets of commercial banks? How has each of these factors been related to the
change and development of the financial services industry during the 1990s and early

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2000s? What strategic changes have banks implemented to deal with changes in the
financial services environment?

Corporations have utilized the commercial paper markets with increased frequency rather than
borrow from banks. In addition, many banks have sold loan packages directly into the capital
markets (securitization) as a method to reduce balance sheet risks and to improve liquidity.
Finally, the decrease in loan volume during the early 1990s and early 2000s was due in part to
the recession in the economy.

As deregulation of the financial services industry continued during the 1990s, the position of
banks as the primary financial services provider continued to erode. Banks of all sizes have
increased the use of off-balance sheet activities in an effort to generate additional fee income.
Letters of credit, futures, options, swaps and other derivative products are not reflected on the
balance sheet, but do provide fee income for the banks.

4. What are the major uses of funds for commercial banks in the United States? What are the
primary risks to the bank caused by each use of funds? Which of the risks is most critical
to the continuing operation of the bank?

Loans and investment securities continue to be the primary assets of the banking industry.
Commercial loans are relatively more important for the larger banks, while consumer, small
business loans, and residential mortgages are more important for small banks. Each of these
types of loans creates credit, and to varying extents, liquidity risks for the banks. The security
portfolio normally is a source of liquidity and interest rate risk, especially with the increased use
of various types of mortgage backed securities and structured notes. In certain environments,
each of these risks can create operational and performance problems for a bank.

5. What are the major sources of funds for commercial banks in the United States? How is
the landscape for these funds changing and why?

The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily
on transaction, savings, and retail time deposits, while large banks tend to utilize large,
negotiable time deposits and nondeposit liabilities such as federal funds and repurchase
agreements. The supply of nontransaction deposits is shrinking, because of the increased use by
small savers of higher-yielding money market mutual funds,

6. What are the three major segments of deposit funding? How are these segments changing
over time? Why? What strategic impact do these changes have on the profitable operation
of a bank?

Transaction accounts include deposits that do not pay interest and NOW accounts that pay
interest. Retail savings accounts include passbook savings accounts and small, nonnegotiable
time deposits. Large time deposits include negotiable certificates of deposits that can be resold
in the secondary market. The importance of transaction and retail accounts is shrinking due to
the direct investment in money market assets by individual investors. The changes in the deposit
markets coincide with the efforts to constrain the growth on the asset side of the balance sheet.

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7. How does the liability maturity structure of a banks balance sheet compare with the
maturity structure of the asset portfolio? What risks are created or intensified by these
differences?

Deposit and nondeposit liabilities tend to have shorter maturities than assets such as loans. The
maturity mismatch creates varying degrees of interest rate risk and liquidity risk.

8. The following balance sheet accounts have been taken from the annual report for a U.S.
bank. Arrange the accounts in balance sheet order and determine the value of total assets.
Based on the balance sheet structure, would you classify this bank as a community bank,
regional bank, or a money center bank?

Assets Liabilities and Equity


Cash $ 2,660 Demand deposits $ 5,939
Fed funds sold $ 110 NOW accounts $12,816
Investment securities $ 5,334 Savings deposits $ 3,292
Net loans $29,981 Certificates of deposit $ 9,853
Intangible assets $ 758 Other time deposits $ 2,333
Other assets $ 1,633 Short-term Borrowing $ 2,080
Premises $ 1,078 Other liabilities $ 778
Total assets $41,554 Long-term debt $ 1,191
Equity $ 3,272
Total liab. and equity $41,554

This bank has funded the assets primarily with transaction and savings deposits. The certificates
of deposit could be either retail or corporate (negotiable). The bank has very little (5 percent)
borrowed funds. On the asset side, about 72 percent of total assets is in the loan portfolio, but
there is no information about the type of loans. The bank actually is a small regional bank with
$41.5 billion in assets, but the asset structure could easily be a community bank with $41.5
million in assets.

9. What types of activities normally are classified as off-balance-sheet (OBS) activities?

Off-balance-sheet activities include the issuance of guarantees that may be called into play at a
future time, and the commitment to lend at a future time if the borrower desires.

a. How does an OBS activity move onto the balance sheet as an asset or liability?

The activity becomes an asset or a liability upon the occurrence of a contingent event,
which may not be in the control of the bank. In most cases the other party involved with
the original agreement will call upon the bank to honor its original commitment.

b. What are the benefits of OBS activities to a bank?

The initial benefit is the fee that the bank charges when making the commitment. If the
bank is required to honor the commitment, the normal interest rate structure will apply to
the commitment as it moves onto the balance sheet. Since the initial commitment does not

15
appear on the balance sheet, the bank avoids the need to fund the asset with either deposits
or equity. Thus the bank avoids possible additional reserve requirement balances and
deposit insurance premiums while improving the earnings stream of the bank.

c. What are the risks of OBS activities to a bank?

The primary risk to OBS activities on the asset side of the bank involves the credit risk of
the borrower. In many cases the borrower will not utilize the commitment of the bank until
the borrower faces a financial problem that may alter the credit worthiness of the borrower.
Moving the OBS activity to the balance sheet may have an additional impact on the interest
rate and foreign exchange risk of the bank.

10. Use the data in Table 2-6 to answer the following questions.

a. What was the average annual growth rate in OBS total commitments over the period
from 1992-2003?

$78,035.6 = $10,200.3(1+g)11 g = 20.32 percent

b. Which categories of contingencies have had the highest annual growth rates?

Category of Contingency or Commitment Growth Rate


Commitments to lend 14.04%
Future and forward contracts 15.13%
Notional amount of credit derivatives 52.57%
Standby contracts and other option contracts 56.39%
Commitments to buy FX, spot, and forward 3.39%
Standby LCs and foreign office guarantees 7.19%
Commercial LCs -1.35%
Participations in acceptances -6.11%
Securities borrowed 20.74%
Notional value of all outstanding swaps 31.76%

Standby contracts and other option contracts have grown at the fastest rate of 56.39
percent, and they have an outstanding balance of $214,605.3 billion. The rate of growth in
the credit derivatives area has been the second strongest at 52.57 percent, the dollar volume
remains fairly low at $1,001.2 billion at year-end 2003. Interest rate swaps grew at an
annual rate of 31.76 percent with a change in dollar value of $41,960.7 billion. Clearly the
strongest growth involves derivative areas.

c. What factors are credited for the significant growth in derivative securities activities by
banks?

The primary use of derivative products has been in the areas of interest rate, credit, and
foreign exchange risk management. As banks and other financial institutions have pursued

16
the use of these instruments, the international financial markets have responded by
extending the variations of the products available to the institutions.

11. For each of the following banking organizations, identify which regulatory agencies (OCC,
FRB, FDIC, or state banking commission) may have some regulatory supervision
responsibility.

(a) State-chartered, nonmember, nonholding-company bank.


(b) State-chartered, nonmember holding-company bank
(c) State-chartered member bank
(d) Nationally chartered nonholding-company bank.
(e) Nationally chartered holding-company bank

Bank Type OCC FRB FDIC SBCom.


(a) Yes Yes
(b) Yes Yes Yes
(c) Yes Yes Yes
(d) Yes Yes Yes
(e) Yes Yes Yes

12. What factors normally are given credit for the revitalization of the banking industry during
the decade of the 1990s? How is Internet banking expected to provide benefits in the
future?

The most prominent reason was the lengthy economic expansion in both the U.S. and many
global economies during the entire decade of the 1990s. This expansion was assisted in the U.S.
by low and falling interest rates during the entire period.

The extent of the impact of Internet banking remains unknown. However, the existence of this
technology is allowing banks to open markets and develop products that did not exist prior to the
Internet. Initial efforts have focused on retail customers more than corporate customers. The
trend should continue with the advent of faster, more customer friendly products and services,
and the continued technology education of customers.

13. What factors are given credit for the strong performance of commercial banks in the early
2000s?

The lowest interest rates in many decades helped bank performance on both sides of the balance
sheet. On the asset side, many consumers continued to refinance homes and purchase new
homes, an activity that caused fee income from mortgage lending to increase and remain strong.
Meanwhile, the rates banks paid on deposits shrunk to all-time lows. In addition, the
development and more comfortable use of new financial instruments such as credit derivatives
and mortgage backed securities helped banks ease credit risk off the balance sheets. Finally,
information technology has helped banks manage their risk more efficiently.

17
14. What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994? What major impact on commercial banking activity is expected from this
legislation?

The main feature of the Riegle-Neal Act of 1994 was the removal of barriers to inter-state
banking. In September 1995 bank holding companies were allowed to acquire banks in other
states. In 1997, banks were allowed to convert out-of-state subsidiaries into branches of a single
interstate bank. As a result, consolidations and acquisitions have allowed for the emergence of
very large banks with branches across the country.

15. What happened in 1979 to cause the failure of many savings associations during the early
1980s? What was the effect of this change on the operating statements of savings
associations?

The Federal Reserve changed its reserve management policy to combat the effects of inflation, a
change which caused the interest rates on short-term deposits to increase dramatically more than
the rates on long-term mortgages. As a result, the marginal cost of funds exceeded the average
yield on assets that caused a negative interest spread for the savings associations. Further,
because savings associations were constrained by Regulation Q on the amount of interest which
could be paid on deposits, they suffered disintermediation, or deposit withdrawals, which led to
severe liquidity pressures on the balance sheets.

16. How did the two pieces of regulatory legislation, the DIDMCA in 1980 and the DIA in
1982, change the operating profitability of savings associations in the early 1980s? What
impact did these pieces of legislation ultimately have on the risk posture of the savings
association industry? How did the FSLIC react to this change in operating performance
and risk?

The two pieces of legislation allowed savings associations to offer new deposit accounts, such as
NOW accounts and money market deposit accounts, in an effort to reduce the net withdrawal
flow of deposits from the institutions. In effect this action was an attempt to reduce the liquidity
problem. In addition, the savings associations were allowed to offer adjustable-rate mortgages
and a limited amount of commercial and consumer loans in an attempt to improve the
profitability performance of the industry. Although many savings associations were safer, more
diversified, and more profitable, the FSLIC did not foreclose many of the savings associations
which were insolvent. Nor did the FSLIC change its policy of assessing higher insurance
premiums on companies that remained in high risk categories. Thus many savings associations
failed, which caused the FSLIC to eventually become insolvent.

17. How do the asset and liability structures of a savings association compare with the asset
and liability structures of a commercial bank? How do these structural differences affect
the risks and operating performance of a savings association? What is the QTL test?

The savings association industry relies on mortgage loans and mortgage-backed securities as the
primary assets, while the commercial banking industry has a variety of loan products, including
mortgage products. The large amount of longer-term fixed rate assets continues to cause interest

18
rate risk, while the lack of asset diversity exposes the savings association to credit risk. Savings
associations hold considerably less cash and U.S. Treasury securities than do commercial banks.
On the liability side, small time and saving deposits remain as the predominant source of funds
for savings associations, with some reliance on FHLB borrowing. The inability to nurture
relationships with the capital markets also creates potential liquidity risk for the savings
association industry.

The acronym QTL stands for Qualified Thrift Lender. The QTL test refers to a minimum
amount of mortgage-related assets that a savings association must hold. The amount currently is
65 percent of total assets.

18. How do savings banks differ from savings and loan associations? Differentiate in terms of
risk, operating performance, balance sheet structure, and regulatory responsibility.

The asset structure of savings banks is similar to the asset structure of savings associations with
the exception that savings banks are allowed to diversify by holding a larger proportion of
corporate stocks and bonds. Savings banks rely more heavily on deposits and thus have a lower
level of borrowed funds. The banks are regulated at both the state and federal level, with
deposits insured by the FDICs BIF.

19. How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of
1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse
some of the key features of earlier legislation?

FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and the
Garn-St Germain Act of 1982 by instituting the qualified thrift lender (QTL) test that requires
that all thrifts must hold portfolios that are comprised primarily of mortgages or mortgage
products such as mortgage-backed securities. The act also required thrifts to divest their
portfolios of junk bonds by 1994, and it replaced the FSLIC with a new thrift deposit insurance
fund, the Savings Association Insurance Fund, which was managed by the FDIC.

The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurance
premiums in 1993 to reduce excess risk-taking. FDICA also provided for the implementation of
a policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly in
cases where insolvency is imminent. Thus the ill-advised policy of regulatory forbearance
should be curbed. Finally, the act amended the International Banking Act of 1978 by expanding
the regulatory oversight powers over foreign banks.

20. What is the common bond membership qualification under which credit unions have
been formed and operated? How does this qualification affect the operational objective of
a credit union?

The common bond policy allows any one who meets a specific membership requirement to
become a member of the credit union. The requirement normally is tied to a place of
employment. Because the common bond policy has been loosely interpreted, implementation
has allowed credit union membership and assets to grow at a rate that exceeds similar growth in

19
the commercial banking industry. Since credit unions are mutual organizations where the
members are owners, employees essentially use saving deposits to make loans to other
employees who need funds.

21. What are the operating advantages of credit unions that have caused concern by
commercial bankers? What has been the response of the Credit Union National
Association to the bank criticisms?

Credit unions are tax-exempt organizations that often are provided office space by employers at
no cost. As a result, because non-interest operating costs are very low, credit unions can lend
money at lower rates and pay higher rates on savings deposits than can commercial banks.
CUNA has responded that the cost to tax payers from the tax-exempt status is replaced by the
additional social good created by the benefits to the members.

22. How does the asset structure of credit unions compare with the asset structure of
commercial banks and savings and loan associations? Refer to Tables 2-5, 2-9, and 2-12 to
formulate your answer.

The relative proportions of credit union assets are more similar to commercial banks than savings
associations, with 20 percent in investment securities and 63 percent in loans. However,
nonmortgage loans of credit unions are predominantly consumer loans. On the liability side of
the balance sheet, credit unions differ from banks in that they have less reliance on large time
deposits, and they differ from savings associations in that they have virtually no borrowings from
any source. The primary sources of funds for credit unions are transaction and small time and
savings accounts.

23. Compare and contrast the performance of the U.S. depository institution industry with
those of Japan, China, and Germany.

The entire Japanese financial system was under increasing pressure from the early 1990s as the
economy suffered from real estate and other commercial industry pressures. The Japanese
government has used several financial aid packages in attempts to avert a collapse of the
Japanese financial system. Most attempts have not been successful.

The deterioration in the banking industry in China in the early 2000s was caused by
nonperforming loans and credits. The remedies include the opportunity for more foreign bank
ownership in the Chinese banking environment primarily via larger ownership positions, less
restrictive capital requirements for branches, and increased geographic presence.

German banks also had difficulties in the early 2000s, but the problems were not universal. The
large banks suffered from credit problems, but the small banks enjoyed high credit ratings and
low cast of funds because of government guarantees on their borrowing. Thus while small banks
benefited from growth in small business lending, the large banks became reliant on fee and
trading income.

20
Chapter Three
The Financial Services Industry: Insurance Companies
Chapter Outline

Introduction

Life Insurance Companies


Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation

Property-Casualty Insurance
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation

Global Issues

Summary

21
Solutions for End-of-Chapter Questions and Problems: Chapter Three

1. What is the primary function of an insurance company? How does this function compare
with the primary function of a depository institution?

The primary function of an insurance company is to provide protection from adverse events. The
insurance companies accept premium payments in exchange for compensation in the event that
certain specified, but undesirable, events occur.

The primary function of depository institutions is to provide financial intermediation for


individual and corporate savers. By accepting deposits and making loans, depository institutions
allow savers with predominantly small, short-term financial assets to benefit from investments in
larger, longer-term assets. These long-term assets typically yield a higher rate of return than
short-term assets.

2. What is the adverse selection problem? How does adverse selection affect the profitable
management of an insurance company?

The adverse selection problem occurs because customers who are most in need of insurance are
most likely to acquire insurance. However, the premium structure for various types of insurance
typically is based on an average population proportionately representing all categories of risk.
Thus the existence of a proportionately larger share of high-risk customers may cause the
premium revenue received by the insurance provider to underestimate the necessary revenue to
cover the insured liabilities and to provide a reasonable profit for the insurance company.

3. What are the similarities and differences among the four basic lines of life insurance
products?

The four basic lines of life insurance products are (1) ordinary life; (2) group life; (3) industrial
life; and (4) credit life. Ordinary life is sold on an individual basis and represents the largest
segment (60%) of the life insurance market. The insurance policy can be structured as pure life
insurance (term life) or may contain a savings component (whole life or universal life). Group
policies (40%) are similar to ordinary life insurance policies except that they are centrally
administered, providing cost economies in evaluating, screening, selling, and servicing the
policies. Industrial life (<1.0%) has largely been replaced by group life since cost economies
have made group life more affordable. Industrial life was historically marketed to individuals
who would make small, very frequent payments and would require personal collection services.
Credit life (<2.0%) typically is term life sold in conjunction with some debt contract

4. Explain how annuity activities represent the reverse of life insurance activities.

A typical life insurance contract requires a periodic payment by one party for a promised
payment of either a lump sum or an annuity if a particular event occurs, such as death or an
accident. An annuity represents a reverse contract where the party purchases the right to receive
periodic payments depending on the market conditions. The contract may be initiated by
investing a lump sum or by making periodic payments before the annuity payments begin.

22
5. Explain how life insurance and annuity products can be used to create a steady stream of
cash disbursements and payments to avoid either paying or receiving a single-lump sum
cash amount.

A life insurance policy (whole life or universal life) requires regular premium payments that
entitle the beneficiary to the receipt of a single lump sum payment. Upon receipt of such a lump
sum, a single annuity could be obtained which would generate regular cash payments until the
value of the insurance policy is depleted.

6. a. Calculate the annual cash flows of a $1 million, 20-year fixed-payment annuity earning
a guaranteed 10 percent per annum if payments are to begin at the end of the current
year.

The annual cash flows are given by X:



1 - ( 1.10 )
-20
$1,000,000 = X ( PVA i= 10%, n = 20 ) X
0.10

where PVA is obtained from the present value annuity tables with 1 = 10 percent and n =
20 years. The value for X is $117,459.62.

b. Calculate the annual cash flows of a $1 million, 20-year fixed-payment annuity earning
a guaranteed 10 percent per annum if payments are to begin at the end of year five.

In this case, the first annuity is to be received five years from today. The initial sum today
will have to be compounded by four periods to estimate the annuities:


1 - ( 1+ .10 )
-20
$1,000 ,000 (1+ 0.10 ) = X ( PVA i= 10%, n = 20 ) X
4

0.10

X = $171,972.64

c. What is the amount of the annuity purchase required if you wish to receive a fixed
payment of $200,000 for 20 years? Assume that the annuity will earn 10 percent per
annum.

The required payment is the present value of $200,000 per year for 20 years at 10 percent.


1 - (1.10 )
-20
$1,702 ,712 .74 = $200,000 ( PVAi = 10%, n = 20 ) $200,000
0.10

7. You deposit $10,000 annually into a life insurance fund for the next 10 years, after which
time you plan to retire.

23
a. If the deposits are made at the beginning of the year and earn an interest rate of 8
percent, what will be the amount of retirement funds at the end of year 10?

(1.08)10 1
$156, 454.87 $10,000 FVA Beg
i 8%, n 10 $10,000 (1.08)
0.08

b. Instead of a lump sum, you wish to receive annuities for the next 20 years (years 11
through 30). What is the constant annual payment you expect to receive at the
beginning of each year if you assume an interest rate of 8 percent during the
distribution period?

In this case, the first annuity is to be received ten years from today. The amount of
retirement funds at the end of year ten (the answer to part (a) of $156,454.87) will be paid
out over twenty years with the first payment to be received immediately.


1 - (1+ .08) 19
8%, n 20 ) X
$156 ,454.87 = X ( PVAiBeg 1
0.08

X = $14,754,88

c. Repeat parts (a) and (b) above assuming earning rates of 7 percent and 9 percent during
the deposit period, and earning rates of 7 percent and 9 percent during the distribution
period. During which period does the change in the earning rate have the greatest
impact?

Deposit Value at Distribution Annual


Period 10 Years Period Payment
7 percent $147,835.99 7 percent $13,041.75
9 percent $14,857.72

9 percent $165,602.93 7 percent $14,609.11


9 percent $16,643.32
If you earn only 7 percent during the deposit period, earning 9 percent during the
distribution period will barely allow you to better the distribution of the 8 percent/8 percent
pattern in parts (a) and (b). But if you earn 9 percent during the deposit period, the
distribution amount at 7 percent will almost match the 8 percent/8 percent pattern.

8. a. Suppose a 65-year-old person wants to purchase an annuity from an insurance company


that would pay $20,000 per year until the end of that persons life. The insurance
company expects this person to live for 15 more years and would be willing to pay 6
percent on the annuity. How much should the insurance company ask this person to
pay for the annuity?
Lump sum $20,000 xPVA r 6%, n 15 $194,244.98

24
b. A second 65-year-old person wants the same $20,000 annuity, but this person is much
healthier and is expected to live for 20 years. If the same 6 percent interest rate applies,
how much should this healthier person be charged for the annuity?

Lump sum $20,000 xPVAr 6 %, n20 $229,398.42

c. In each case, what is the difference in the purchase price of the annuity if the
distribution payments are made at the beginning of the year?

For 15 years, the lump sum is $205,899.68. For 20 years, the lump sum is $243,162.33.

9. Contrast the balance sheet of a life insurance company with the balance sheet of a
commercial bank and that of a savings association. Explain the balance sheet differences in
terms of the differences in the primary functions of the three organizations.

Life insurance companies have long-term liabilities because of the life insurance products that
they sell. As a result, the asset side of the balance sheet predominantly includes long-term
government and corporate bonds, corporate equities, and a declining amount of mortgage
products. The asset side of a commercial banks balance sheet is comprised primarily of short-
and medium-term loans to corporations and individuals and some treasury securities. The
principal asset category for a savings association is long-term mortgages.

In effect, all three companies use large degrees of financial leverage to fund assets that primarily
consist of debt securities. While the face value of deposits is fixed for banks and savings
associations, the composition of liabilities for insurance companies is stochastic. The primary
liability category for a life insurance company is policy reserves that reflect the expected
payment commitments on existing policy contracts. Insurance companies also sell short- and
medium-term debt instruments called GICs that are used to fund their pension plan business.
The liabilities of savings associations are primarily short-term deposit accounts, while banks
utilize short-term deposits and short-term borrowed funds, depending on the size of the bank.

10. Using the data in Table 3-2, how has the composition of assets of U.S. life insurance
companies changed over time?

Table 3-2 indicates that life insurance companies have increased their holdings of bonds and
stocks and decreased their holdings of mortgages and policy loans since the 1920s and 1930s.
Government securities comprise the second largest component, although the proportion seems to
be decreasing in recent years as the yields have decreased.

11. How do life insurance companies earn profits?

Insurance firms earn profits by taking in more premium income than they pay out in policy
payments. Firms can increase their spread between premium income and policy payouts in two
ways. The first way is to decrease future required payouts for any given level of premium
payments. This can be accomplished by reducing the risk of the insured pool (provided the
policyholders do not demand premium rebates that fully reflect lower expected future payouts).

25
The second way is to increase the profitability of interest income on net policy reserves. Since
insurance liabilities typically are long term, the insurance company has long periods of time to
invest premium payments in interest earning asset portfolios. The higher is the yield on the
insurance company's investments, the greater is the difference between the premium income
stream and the policy payouts (except in the case of variable life insurance) and the greater is the
insurance company's profitability.

Because junk bonds offer high yields, they offer insurance companies an opportunity to increase
the return on their asset portfolio. However, junk bonds are more risky than government or
investment grade corporate bonds. As a result of the recent failures of some life insurance firms,
the NAICs proposed new Model Investment Law has limited the holding of junk bonds in the
asset portfolios of insurance companies.

12. How would the balance sheet of a life insurance company change if it offered to run a
private pension fund to another company?

The primary change in the balance sheet of a life insurance company would be an increase in the
liability accounts that reflect these pension plans. Guaranteed investment contracts (GICs) and
separate account categories likely would increase, depending on the type of pension plans
provided to the customers. The premiums and contributions would be invested in the normal
asset categories of the insurance company, except in cases where the pension fund requires
aggressive investment strategies. In this case, the funds may be invested in specific equity
mutual funds.

13. How does the regulation of insurance companies differ from the regulation of depository
institutions? What are the major pieces of life insurance regulatory legislation?

Insurance companies are more exclusively subject to state regulations compared to banks and
thrifts. Although there are national insurance organizations such as the National Association of
Insurance Commissioners, the companies are chartered and regulated at the state level. Banks
and thrifts are typically subject to both national and state oversight. While both banks and
insurance companies receive regulatory scrutiny as to the quality of their assets and liabilities,
bank regulations also dictate minimum reserve and capital requirements. Banks have more
geographic restrictions. Both insurance companies and banks are limited in the products that
they can offer. The primary legislation is the McCarran-Ferguson Act of 1945. This legislation
provides that federal regulation is subordinate to state regulation.

14. How do state guarantee funds for life insurance companies compare with deposit insurance
for commercial banks and thrifts?

State guarantee funds are different from deposit insurance in several ways. First, the insurance
guarantee funds are administered by the life insurance companies as opposed to a separate
company like the FDIC for deposit institutions. Second, insurance companies do not pay
premiums into the guarantee fund until after the failure of an insurance company. The FDIC
requires annual premium payments from all deposit institutions. Third, while the FDIC requires
premium payments to be based on the amount of deposits and the risk of the assets of the banks,

26
the contributions by insurance companies typically are based on the relative amount of premium
income received by the surviving insurance companies. Finally, because contributions to the
insurance guarantee funds are requested only after the failure of a company, the transmission of
the benefits to the policyholders occurs only after a reasonable delay. In contrast, the FDIC
normally pays depositors within a few days after the failure of a commercial bank or a thrift.

15. What are the two major activity lines of property-casualty insurance firms?

The two major lines of property-casualty insurance are:

a) Property insurance: Insurance compensating the insured, fully or partially, for personal
or commercial property damage as a result of accidents and other events; and

b) Liability insurance: Insurance compensating a third party, fully or partially, because its
personal or commercial property was damaged as a result of the accidental actions of
the insured.

In many cases, property and liability insurance is sold together, such as personal or commercial
multiple peril and auto insurance. Fire and allied lines usually are sold as property insurance
only. Liability insurance is sold separately for coverage such as malpractice or product liability
hazards. In addition, reinsurance provides a means for primary insurers to pool their risk by
transferring some of the risk and premium to a reinsurer.

16. How have the product lines of property-casualty insurance companies changed over time?

Product lines based on net premiums typically are included in the property-casualty insurance
arena. The largest decreases have been in the fire and allied categories, while the multiple peril
(or umbrella) and liability policies have shown the largest increases. The changes are related in
that much of the decreased coverage has been subsumed into the multiple peril policies.

17. Contrast the balance sheet of a property-casualty insurance company with the balance sheet
of a commercial bank. Explain the balance sheet differences in terms of the differences in
the primary functions of the two organizations.

The balance sheet of a PC company is similar to that of a life insurance company. Long-term
financial assets such as bonds, common equities and preferred stock comprise the majority of the
assets, while loss reserves, loss adjustment expenses, and unearned premiums dominate the
liabilities. In contrast, short-and medium-term financial assets dominate the asset side of the
balance sheets of most banks, and borrowed funds in the form of deposits are the primary
liability for commercial banks. Whereas banks provide time and size intermediation for
depositors, PC insurance companies use premium payments to provide assurance against certain
types of risk for customers. For a bank the deposits represent borrowed funds, while the
premiums to an insurance company represent the actual price for the risk coverage.

18. What are the three sources of underwriting risk in the property-casualty insurance industry?

27
The three sources of underwriting risk in the PC industry are (a) unexpected increases in loss
rates, (b) unexpected increases in expenses, and (c) unexpected decreases in investment yields.
Loss rates are influenced by whether the product lines are property or liability (with the latter
being less predictable), whether they are low-severity high-frequency lines or high-severity low-
frequency lines (with the latter being more difficult to estimate), and whether they are long-tail
or short-tail lines (with the former being more difficult to estimate). Loss rates also are affected
by product and social inflation. Unexpected increases in expenses are a result of increases in
commission costs to brokers, general expenses, taxes and other expenses related to acquisitions.
Finally, investment yields depend on the stock and bond markets as well as on the asset
allocations of the portfolios.

19. How do unexpected increases in inflation affect property-casualty insurers?

Inflation generally has an adverse effect on the cost of providing the benefits that have been
purchased by the insured, particularly if the policy is written in terms of the replacement cost of
the asset and the premiums are not adjusted for inflation. In addition, the investment value of the
bonds and other fixed-rate assets of insurers from which claims proceeds are derived may
decrease in value from unexpected inflation.

20. Identify the four characteristics or features of the perils insured against by property-
casualty insurance. Rank the features in terms of actuarial predictability and total loss
potential.

Property versus liability: Maximum levels of losses are more predictable for property lines
than for liability lines.
Severity versus frequency: Loss rates are more predictable on low-severity, high-frequency
lines than they are on high-severity, low-frequency lines.
Time of exposure: The extent of expected losses is more difficult for long-tail risk exposure
phenomenon than for short-tail exposures.
Inflation: The inflation risk of property lines is likely to reflect the underlying inflation of
the economy, while the inflation risk of liability lines may be subject to the changing values
or social risk of the society.

21. Insurance companies will charge a higher premium for which of the insurance lines listed
below? Why?

a. Low-severity, high-frequency lines versus high-severity, low-frequency lines.

Insurance companies have a more difficult time predicting the severity of losses for high-
severity low-frequency lines of business, such as earthquakes and hurricanes. In addition,
these catastrophic events cause severe damage, meaning the individual risks in the insured
pool are not independent. As a result, premiums for high-severity low-frequency lines will
be charged higher premiums than low-severity high-frequency lines.

b. Long-tail versus short-tail lines.

28
Similarly, losses in long-tail lines of business are harder to predict than in short-tail lines,
because claims can be made years after the premiums have been made. Thus, premiums in
this category of business will be higher. Modern day examples of such lines include
coverage for product liabilities, such as exposure to asbestos or chemicals like agent-
orange.

22. What does the loss ratio measure? What has been the long-term trend of the loss ratio?
Why?

The loss ratio measures the actual losses incurred on a line of insurance relative to the premium
earned on the line. A ratio greater than 100 implies that the premiums earned did not cover the
losses on the product line. The loss ratio has increased from the 60 percent range in the early
1950s to 80 percent range in the late 1980s and early 1990s. Increases in social inflation and the
long-tail risk exposure phenomenon have caused some insurance companies to invest in shorter-
term assets that have lower yields and thus generate lower premium earnings. In addition,
increased coverage in areas with higher uncertainty of losses has occurred within the industry.

23. What does the expense ratio measure? Identify and explain the two major sources of
expense risk to a property-casualty insurer. Why has the long-term trend in this ratio been
decreasing?

The expense ratio measures the expenses incurred relative to the premiums written. Expense risk
is comprised primarily of loss adjustment expenses, which relate to the cost surrounding the loss
settlement process, and commission costs paid to insurance brokers and sales agents in an effort
to attract business. Large insurance companies have found expense efficiencies in using their
own brokers rather than using independent brokers to sell insurance.

24. How is the combined ratio defined? What does it measure?

The combined ratio is equal to the loss ratio plus the expense ratio. The ratio may be stated
before or after dividends paid to policyholders. The ratio basically measures the underwiting
profitability of an insurance line. If the combined ratio is less than 100, the premiums on the
insurance have been sufficient to cover both losses and expenses on line.

25. What is the investment yield on premiums earned? Why has this ratio become so important
to property-casualty insurers?

In cases where the combined ratio is greater than 100, the insurer must rely on investment
income from premiums to achieve profitability. Since the 1980s, the combined ratio consistently
has been greater than 100. That is, the loss ratio and the expense ratio have exceeded the amount
of premiums received on the insurance lines. Thus, the yield on invested premiums has become
critical in the overall profitability of the property-casualty insurance industry.

26. Use the data in Table 3-8. Since 1980, what has been the necessary investment yield for
the industry to enable the operating ratio to be less than 100 in each year? How is this

29
requirement related to the interest rate risk and credit risk faced by the property-casualty
insurer?

The minimum investment yield required to achieve an operating ratio of 100 or less ranged from
a low of 0.1 percent in 2003 to a high of 16.3 percent in 1985. The average yield over this
period (for the years reported) was 7.9 percent. In effect, PC insurers required an average annual
yield of 7.9 percent on invested premiums during a time when interest rates were seldom this
high and operating losses were significant. Year-by-year values are given below based on data
given in Table 3-8.

Combined Required Minimum


Ratio after Combined Investment
Year Dividends Ratio Yield
1980 103.1% 100.0% 3.1%
1985 116.3% 100.0% 16.3%
1990 109.6% 100.0% 9.6%
1995 106.4% 100.0% 6.4%
1997 101.6% 100.0% 1.6%
2000 110.5% 100.0% 10.5%
2001 116.0% 100.0% 16.0%
2002 107.2% 100.0% 7.2%
2003 100.1% 100.0% 0.1%

Arithmetic Average = 7.9%


Minimum = 0.1%
Maximum = 16.3%

27. An insurance companys projected loss ratio is 77.5 percent, and its loss adjustment
expense ratio is 12.9 percent. The company estimates that commission payments and
dividends to policyholders will be 16 percent. What must be the minimum yield on
investments to achieve a positive operating ratio?

The combined ratio = 77.5% + 12.9% + 16.0% = 106.40%. In order to be profitable, the yield on
investments has to be greater than 6.40%.

28. a. What is the combined ratio for a property insurer who has a simple loss ratio of 73
percent, a loss adjustment expense of 12.5 percent, and a ratio of commissions and
other acquisition expenses of 18 percent?

The combined ratio is 73% + 12.5% + 18% = 103.5%.

b. What is the combined ratio adjusted for investment yield if the company earns an
investment yield of 8 percent?

The combined ratio adjusted for investment yield is 95.5%.

29. An insurance company collected $3.6 million in premiums and disbursed $1.96 million in
losses. Loss adjustment expenses amounted to 6.6 percent, and dividends paid to

30
policyholders totaled 1.2 percent. The total income generated from the companys
investments was $170,000 after all expenses were paid. What is the net profitability in
dollars?

Pure loss = $3.6 million - $1.96 million = $1.64 million, or $1.640,000.


Expenses = 0.066 x $3,600,000 = $237,600.
Dividends = 0.012 x $3,600,000 = $43,200.
Investment returns = $170,000.
Net profits = $1,529,200.

30. What is the underwriting cycle for PC insurers? How do the premiums per unit of risk
differ in the trough versus the peak of an underwriting cycle?

The underwriting cycle reflects the tendency for PC losses to occur in cycles. When large or
many catastrophes occur in relatively short periods of time, the PC insurance industry raises the
premiums on similar-size coverage. This activity occurs during the trough or down phase of the
underwriting cycle. As the relative occurrence of catastrophes slows, the premiums per coverage
amount tend to soften or decrease. This represents the recovery or peak phase of the
underwriting cycle.

31
Chapter Four
The Financial Services Industry: Securities Firms and Investment Banks
Chapter Outline

Introduction

Size, Structure, and Composition of the Industry

Balance Sheet and Recent Trends


Recent Trends
Balance Sheet

Regulation

Global Issues

Summary

32
Solutions for End-of-Chapter Questions and Problems: Chapter Four

1. Explain how securities firms differ from investment banks. In what ways are they financial
intermediaries?

Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while
investment banks primarily engage in originating, underwriting, and distributing issues of
securities. In more recent years, investment banks have undertaken increased corporate finance
activities such as advising on mergers, acquisitions, and corporate restructuring. In both cases,
these firms act as financial intermediaries in that they bring together economic units who need
money with those units who wish to invest money.

2. In what ways have changes in the investment banking industry mirrored changes in the
commercial banking industry?

First, both industries have seen a concentration of business among the larger firms. This
concentration has occurred primarily through the merger and acquisition activities of several of
the largest firms. Second, firms in both industries tend to be divided along product line services
provided to customers. Some national full-line firms provide service to both retail customers, in
the form of brokerage services, and corporate customers, in the form of new issue underwriting.
Other national full-line firms specialize in corporate finance and security trading activities.
Third, the remaining firms specialize in more limited activities such as discount brokerage,
regional full service retail activities, etc. This business line division is not dissimilar to that of
the banking industry with money center banks, regional banks, and community banks. Clearly
product line overlap occurs between the different firm divisions in each industry.

3. What are the different types of firms in the securities industry, and how does each type
differ from the others?

The firms in the security industry vary by size and specialization. They include:

a) National, full-line firms servicing both retail and corporate clients, such as Merrill
Lynch.
b) National firms specializing in corporate finance and trading, such as Goldman Sachs,
Salomon Brothers and Morgan Stanley.
c) Securities firms providing investment banking services that are subsidiaries of
commercial banks. These subsidiaries continue to make inroads into the markets held
by traditional investment banks as the restrictions imposed by the Glass-Steagall Act,
which separates commercial banking from investment banking, are slowly removed.
d) Specialized discount brokers providing trading services such as the purchase and sale of
stocks, without offering any investment tips, advice or financial counseling.
e) Regional securities firms that offer most of the services mentioned above but restrict
their activities to specific geographical locations.

4. What are the key activity areas for securities firms? How does each activity area assist in
the generation of profits, and what are the major risks for each area?

33
The seven major activity areas of security firms are:

a) Investing: Securities firms act as agents for individuals with funds to invest by
establishing and managing mutual funds and by managing pension funds. The securities
firms generate fees that affect directly the revenue stream of the companies.

b) Investment Banking: Investment banks specialize in underwriting and distributing both


debt and equity issues in the corporate market. New issues can be placed either
privately or publicly and can represent either a first issued (IPO) or a secondary issue.
Secondary issues of seasoned firms typically will generate lower fees than an IPO. In a
private offering the investment bank receives a fee for acting as the agent in the
transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee
based on the success of the offering. The firm serves as a principal by actually takes
ownership of the securities in a firm commitment underwriting. Thus the risk of loss is
higher. Finally, the firm may perform similar functions in the government markets and
the asset-backed derivative markets. In all cases, the investment bank receives fees
related to the difficulty and risk in placing the issue.

c) Market Making: Security firms assist in the market-making function by acting as


brokers to assist customers in the purchase or sale of an asset. In this capacity the firms
are providing agency transactions for a fee. Security firms also take inventory positions
in assets in an effort to profit on the price movements of the securities. These principal
positions can be profitable if prices increase, but they can also create downside risk in
volatile markets.

d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The
activities usually involve position trading, pure arbitrage, risk arbitrage, and program
trading. Position trading involves the purchase of large blocks of stock to facilitate the
smooth functioning of the market. Pure arbitrage involves the purchase and
simultaneous sale of an asset in different markets because of different prices in the two
markets. Risk arbitrage involves establishing positions prior to some anticipated
information release or event. Program trading involves positioning with the aid of
computers and futures contracts to benefit from small market movements. In each case,
the potential risk involves the movements of the asset prices, and the benefits are aided
by the lack of most transaction costs and the immediate information that is available to
investment banks.

e) Cash Management: Cash management accounts are checking accounts that earn interest
and may be covered by FDIC insurance. The accounts have been beneficial in
providing full-service financial products to customers, especially at the retail level.

f) Mergers and Acquisitions: Most investment banks provide advice to corporate clients
who are involved in mergers and acquisitions. This activity has been extremely
beneficial from a fee standpoint during the 1990s.

34
g) Back-Office Service Functions: Security firms offer clearing and settlement services,
research and information services, and other brokerage services on a fee basis.

5. What is the difference between an IPO and a secondary issue?

An IPO is the first time issue of a companys securities, whereas a secondary offering is a new
issue of a security that is already offered.

6. What is the difference between a private-placement and a public offering?

A public offering represents the sale of a security to the public at large. A private placement
involves the sale of securities to one or several large investors such as an insurance company or a
pension fund.

7. What are the risk implications to the investment banker from underwriting on a best-efforts
basis versus a firm commitment basis? If you operated a company issuing stock for the
first time, which type of underwriting would you prefer? Why? What factors may cause
you to choose the alternative?

In a best efforts underwriting, the investment banker acts as an agent of the company issuing the
security and receives a fee based on the number of securities sold. With a firm commitment
underwriting, the investment banker purchases the securities from the company at a negotiated
price and sells them to the investing public at what it hopes will be a higher price. Thus the
investment banker has greater risk with the firm commitment underwriting, since the investment
banker will absorb any adverse price movements in the security before the entire issue is sold.

Factors causing preference to the issuing firm include general volatility in the market, stability
and maturity of the financial health of the issuing firm, and the perceived appetite for new issues
in the market place. The investment bank will also consider these factors when negotiating the
fees and/or pricing spread in making its decision regarding the offering process.

8. How do agency transactions differ from principal transactions for market makers?

Agency transactions are done on behalf of a customer. Thus the investment banker is acting as a
stockbroker, and the company earns a fee or commission. In a principal transaction, the
investment bank is trading on its own account. In this case the profit is made from the difference
in the price that the company pays for the security and the price at which it is sold. In the first
case the company bears no risk, but in the second case the company is risking its own capital.

9. An investment banker agrees to underwrite a $500,000,000, ten-year, 8 percent semiannual


bond issue for KDO Corporation on a firm commitment basis. The investment banker pays
KDO on Thursday and plans to begin a public sale on Friday. What type of interest rate
movement does the investment bank fear while holding these securities? If interest rates
rise 0.05 percent, or 5 basis points, overnight, what will be the impact on the profits of the
investment banker? What if the market interest rate falls 5 basis points?

35
An increase in interest rates will cause the value of the bonds to fall. If rates increase 5 basis
points over night, the bonds will lose $1,695,036.32 in value. The investment banker will absorb
the decrease in market value, since the issuing firm already has received its payment for the
bonds. If market rates decrease by 5 basis points, the investment banker will benefit by the
$1,702,557.67 increase in market value of the bonds. These two changes in price can be found
with the following two equations respectively:

$1,695 ,036 .32 $20,000 ,000 PVAi 4.025%, n 20 $500,000 ,000 PVi 4 .025 %, n 20 $500 ,000,000

$1,702,557 .67 $20,000,000 PVAi3 .975%, n 20 $500,000,000 PVi 3.975%, n 20 $500,000,000

10. An investment banker pays $23.50 per share for 4,000,000 shares of JCN Company. It
then sells these shares to the public for $25 per share. How much money does JCN
receive? What is the profit to the investment banker? What is the stock price of JCN?

JCN receives $23.50 x 4,000,000 shares = $94,000,000. The profit to the investment bank is
($25.00 - $23.50) x 4,000,000 shares = $6,000,000. The stock price of JCN is $25.00 since that
is what the public must pay. From the perspective of JCN, the $6,000,000 represents the
commission that it must pay to issue the stock.

11. XYZ, Inc. has issued 10,000,000 new shares. An investment banker agrees to underwrite
these shares on a best-efforts basis. The investment banker is able to sell 8,400,000 shares
for $27 per share, and it charges XYZ $0.675 per share sold. How much money does XYZ
receive? What is the profit to the investment banker? What is the stock price of XYZ?

XYZ receives $226,800,000, the investment bankers profit is $5,670,000, and the stock price is
$27 per share since that is what the public pays. The net proceeds after commission to XYZ is
$221,130,000.

12. One of the major activity areas of securities firms is trading.

a. What is the difference between pure arbitrage and risk arbitrage?

Pure arbitrage involves the buying and selling of similar assets trading at different prices.
Pure arbitrage has a lock or assurance of the profits that are available in the market. This
profit position usually occurs with no equity investment, the use of only very short-term
borrowed funds, and reduced transaction costs for securities firms.

Risk arbitrage also is based on the principle of buying low and selling high a similar asset
(or an asset with the same payoff). The difference between risk arbitrage and pure arbitrage
is that the prices are not locked in, leaving open a certain speculative component that could
result in real economic losses.

b. What is the difference between position trading and program trading?

36
Position trading involves the purchase of large blocks of stock for the purpose of providing
consistency and continuity to the secondary markets. In most cases, these trades are held in
inventory for a period of time, either after or prior to the trade. Program trading involves
the ability to buy or sell entire portfolios of stocks quickly and often times simultaneously
in an effort to capture differences between the actual futures price of a stock index and the
theoretically correct price. The program trading process is useful when conducting index
arbitrage. If the futures price were too high, an arbitrager would short the futures contract
and buy the stocks in the underlying index. The program trading process in effect is a
coordinated trading program that allows for this arbitrage process to be accomplished.

13. If an investor observes that the price of a stock trading in one exchange is different from
the price in another exchange, what form of arbitrage is applicable, and how can the
investor participate in that arbitrage?

The investor should short sell the more expensive asset and use the proceeds to purchase
the cheaper stock to lock in a given spread. This transaction would be an example of a pure
arbitrage rather than risk arbitrage. The actual spread realized would be affected by the
amount of transaction costs involved in executing the transactions.

14. An investor notices that an ounce of gold is priced at $318 in London and $325 in New
York.

a. What action could the investor take to try to profit from the price discrepancy?

An investor would try to buy gold in London at $318 and sell it in New York for $325
yielding a riskless profit of $7 per ounce.

b. Under which of the four trading activities would this action be classified?

This transaction is an example of pure arbitrage.

c. If the investor is correct in identifying the discrepancy, what pattern should the two
prices take in the short-term future?

The prices of gold in the two separate markets should converge or move toward each other.
In all likelihood the prices will not become exactly the same. It does not matter which
price moves most, since the investor should unwind both positions when the prices are
nearly equal.

d. What may be some impediments to the success of the transaction?

The success or profitability of this arbitrage opportunity will depend on transaction costs
and the speed at which the investor can execute the transactions. If the price disparity is
sufficiently large, other investors will seize the opportunity to attempt to achieve the same
arbitrage results, thus causing the prices to converge quickly.

37
15. What three factors are given credit for the steady decline in brokerage commissions as a
percent of total revenues over the period beginning in 1977 and ending in 1991?

The reasons often offered for the decline in brokerage commissions over the last twenty years are
the abolition of fixed commissions by the SEC in 1975, the resulting competition among firms,
and the stock market crash of 1987. The stock market crash caused a decline in the amount of
equity and debt underwriting which subsequently had a negative effect on income. Although the
equity markets have rebounded during the 1990s, the continued growth of discount brokerage
firms by depository institutions and the advances of electronic trade will likely affect
commissions for an extended period of time.

16. What factors are given credit for the resurgence of profitability in the securities industry
beginning in 1991? Are firms that trade in fixed-income securities more or less likely to
have volatile profits? Why?

Profits for securities firms increased beginning in 1991 because of (a) the resurgence of stock
markets and trading volume, (b) increases in the profits of fixed-income trading, and (c)
increased growth in the underwriting of new issues, especially corporate debt issues.

However, profits from trading in fixed-income instruments are volatile, especially if interest rate
changes are rather common. Hence, even though profits in fixed-income trading were up in
1993, they declined in 1994 because interest rates increased quite suddenly. Many firms with
exposed interest rate instruments reported large losses.

17. Using Table 4-6, which type of security accounts for most underwriting in the United
States? Which is likely to be more costly to underwrite: corporate debt or equity? Why?

According to Table 4-6, debt issues were greater than equity issues by a ratio of roughly four to
one in the middle 1980s and a ratio of sixteen to one in the early 2000s. Debt is less risky than
equity, so there is less risk of an adverse price movement with debt compared to equity. Further,
debt is more likely to be bought in larger blocks by fewer investors, a transaction characteristic
that makes the selling process less costly.

18. How do the operating activities, and thus the balance sheet structures, of securities firms
differ from the operating activities of depository institutions such as commercial banks and
insurance firms? How are the balance sheet structures of securities firms similar to other
financial intermediaries?

The short-term nature of many of the assets in the portfolios of securities firms demonstrates that
an important activity is trading/brokerage. As a broker, the securities firm receives a
commission for handling the trade but does not take either an asset or liability position. Thus,
many of the assets appearing on the balance sheets of securities firms are cash-like money
market instruments, not capital market positions. In the case of commercial banks, assets tend to
be medium term from the lending position of the banks. Insurance company assets tend to be
invested reserves caused by the longer-term liabilities on the balance sheet.

38
A major similarity between securities firms and all other types of FIs is a high degree of financial
leverage. That is, all of these firms use high levels of debt that is used to finance an asset
portfolio consisting primarily of financial securities. A difference in the funding is that securities
firms tend to use liabilities that are extremely short term (see the balance sheet in Table 4-7).
Nearly 33 percent of the total liability financing is payables incurred in the transaction process.
In contrast, depository institutions have fixed-term time and savings deposit liabilities and life
insurance companies have long-term policy reserves.

19. Based on the data in Table 4-7, what were the second largest single asset and the largest
single liability of securities firms in 2003? Are these asset and liability categories related?
Exactly how does a repurchase agreement work?

The second largest asset category was a reverse repurchase agreement, and the largest liability
was a repurchase agreement. When a financial institution needs to borrow funds, one source is
to sell an asset. In the case of financial assets, the institution often finds it more beneficial to sell
the asset under an agreement to repurchase the asset at a later time. In this case, the current
money market rate of interest is built into the agreed upon repurchase price, and the asset
literally does not leave the balance sheet of the borrowing institution. The borrowing institution
receives cash and a liability representing the agreement to repurchase. The lending institution,
which has excess funds, replaces cash as an asset with the reverse repurchase agreement.

20. How did the National Securities Markets Improvement Act of 1996 (NSMIA) change the
regulatory structure of the securities industry?

The NSMIA removed most of the regulatory burden that had been imposed by individual states,
effectively giving the SEC exclusive regulatory jurisdiction over securities firms.

21. Identify the major regulatory organizations that are involved with the daily operations of
the investment securities industry, and explain their role in providing smoothly operating
markets.

The New York Stock Exchange and the National Association of Securities Dealers monitor
trading abuses and the capital solvency of securities firms. The SEC provides governance in the
area of underwriting and trading activities of securities firms, and the Securities Investory
Protection Corporation protects investors against losses up to $500,000 when those losses have
been caused by the failure of securities firms.

22. What are the three requirements of the U.S.A. Patriot Act that financial service firms must
implement after October 1, 2003?

FIs must (1) verify the identity of people opening new accounts; (2) maintain records of the
information used to verify the identity; and (3) determine whether the person opening an account
is on a suspected terrorist list.

39
Chapter Five
The Financial Services Industry: Mutual Funds
Chapter Outline

Introduction

Size, Structure, and Composition of the Industry


Historical Trends
Different Types of Mutual Funds
Mutual Fund Objectives
Investor Returns from Mutual Fund Ownership
Mutual Fund Costs

Balance Sheet and Recent Trends


Money Market Funds
Long-Term Funds

Regulation

Global Issues

Summary

Appendix 5A Hedge Funds

40
Solutions for End-of-Chapter Questions and Problems: Chapter Five

1. What is a mutual fund? In what sense is it a financial intermediary?

A mutual fund represents a pool of financial resources obtained from individuals and companies,
which is invested in the money and capital markets. This process represents another method for
economic savers to channel funds to companies and government units that need extra funds.

2. What are money market mutual funds? In what assets do these funds typically invest?
What factors have caused the strong growth in this type of fund since the late 1970s?

Money market mutual funds (MMMFs) invest in assets that have maturities of less than one year.
These assets primarily are Treasury bills, negotiable certificates of deposit, repurchase
agreements, and commercial paper. The growth in MMMFs since the late 1970s initially
occurred because of rising interest rates in the money markets, while Reg Q restricted interest
rates on accounts in depository institutions. Many investors moved their short-term savings from
the depository institutions to the MMMFs as the spread in the earnings rate reached double
digits. A result of this activity was to introduce many investors to the capital markets for the first
time.

3. What are long-term mutual funds? In what assets do these funds usually invest? What
factors caused the strong growth in this type of fund during the 1990s?

Long-term mutual funds primarily invest in assets that have maturities of more than one year.
The most common assets include long-term fixed-income bonds, common stock, and preferred
stocks. Some money market assets are included for liquidity purposes. The growth in these
funds in the 1990s reflected the dramatic increase in equity returns, the reduction in transaction
costs, and the recognition of diversification benefits achievable through mutual funds.

4. Using the data in Table 5-3, discuss the growth and ownership holding over the last twenty
years of long-term funds versus short-term funds.

The dollar investment in the money market mutual funds (MMMF) exceeded the investment in
the long-term funds (LTF) in 1980. However, by 2001, the LTFs had more than a two to one
advantage on the MMMFs, $4,135 billion to $2,241 billion. The LTF grew at an annualized rate
of 22.2 percent, and the MMMF grew at an annualized rate of 17.5 percent. In each type of fund,
the largest investment source was the household sector, with growth of 21.8 percent annual rate
for the LTF and 14.7 percent for the MMMF.

5. Why did the proportion of equities in long-term funds increase from 38.3 percent in 1990
to over 70 percent by 2000, and then decrease to 62 percent in 2002? How might an
investors preference for a mutual funds objectives change over time?

The primary reason for the increased proportion of funds in equities during the 1990s was the
strength of the equity market that was driven by the underlying strength of the economy during

41
this period. Contrarily, as the economy softened in the early 2000s, investors retreated
somewhat from equities as preferred investments.

The pattern of investor preferences may change over the life of an investor for reasons other than
changes in economic activity. Aggressive high growth funds may be preferred during the early
career years of the 20s, 30s, and into the 40s. As investors mature and retirement becomes a
closer reality, investors may switch to a balance of growth and income funds. Finally, at
retirement investors may try to protect their investment savings by switching to high yield stock
and bond funds.

6. How does the risk of short-term funds differ from the risk of long-term funds?

The principal type of risk for short-term funds is interest rate risk, because of the predominance
of fixed-income securities. Because of the shortness of maturity of the assets, which often is less
than 60 days, this risk is mitigated to a large extent. Short-term funds have virtually no liquidity
or default risk because of the types of assets held. Long-term equity funds typically are well
diversified, and the risk is more systematic or market based. Bond funds have extensive interest
rate risk because of their long-term, fixed-rate nature. Sector, or industry-specific, funds have
systematic (market) and unsystematic risk, regardless of whether they are equity or bond funds.

7. What are the economic reasons for the existence of mutual funds; that is, what benefits do
mutual funds provide for investors? Why do individuals rather than corporations hold most
mutual funds?

One major economic reason for the existence of mutual funds is the ability to achieve
diversification through risk pooling for small investors. By pooling investments from a large
number of small investors, fund managers are able to hold well-diversified portfolios of assets.
In addition, managers can obtain lower transaction costs because of the volume of transactions,
both in dollars and numbers, and they benefit from research, information, and monitoring
activities at reduced costs.

Many small investors are able to gain the benefits of the money and capital markets by using
mutual funds. Once an account is opened in a fund, a small amount of money can be invested on
a periodic basis. In many cases the amount of the investment would be insufficient for direct
access to the money and capital markets. On the other hand, corporations are more likely to be
able to diversify by holding a large bundle of individual securities and assets, and money and
capital markets are easily accessible by direct investment. Further, an argument can be made
that the goal of corporations should be to maximize shareholder wealth, not to be diversified.

8. What are the principal demographics of household owners who own mutual funds? What
are the primary reasons why household owners invest in mutual funds?

Investors tend to be in their primary income generating years, are married with college degrees,
have other retirement plans, and prefer equity funds as opposed to bond, hybrid, or money
market funds. Most individuals are using the funds as vehicles for retirement savings, while
many households are using the funds as savings vehicles for childrens education.

42
9. What change in regulatory guidelines occurred in 1998 that had the primary purpose of
giving investors a better understanding of the risks and objectives of a fund?

The SEC recommended that the original lengthy prospectuses, which described the objectives
and investments of a fund, should be replaced by a two-page profile written in plain English.
The profile should be designed to increase the ability of investors to understand the risks and
objectives of the fund.

10. What are the three possible components reflected in the return an investor receives from a
mutual fund?

The investor receives the income and dividends paid by the companies, the capital gains from the
sale of securities by the mutual fund, and the capital appreciation of the underlying assets.

11. An investor purchases a mutual fund for $60. The fund pays dividends of $1.75, distributes
a capital gain of $3, and charges a fee of $3 when the fund is sold one year later for $67.50.
What is the net rate of return from this investment?

The dollar return is $1.75 + $3 + $7.50 - $3 = $9.25. The rate of return is $9.25/$60 = 15.42%.

12. How is the net asset value (NAV) of a mutual fund determined? What is meant by the term
marked-to-market?

Net Asset Value (NAV) is the average market value of each ownership share of the mutual fund.
The total market value of the fund is determined by summing the total value of each asset in the
fund. The value of each asset can be found by multiplying the number of shares of the asset by
the corresponding price of the asset. Dividing this total fund value by the number of shares in
the mutual fund will give the NAV for the fund.

The NAV is calculated at the end of each daily trading session, and thus reflects any adjustments
in value caused by (a) changes in value of the underlying assets, (b) dividend distributions of the
companies held, or (c) changes in ownership of the fund. This process of daily recalculation of
the NAV is called marking-to-market.

13. A mutual fund owns 400 shares of Fiat, Inc., currently trading at $7, and 400 shares of
Microsoft, Inc., currently trading at $70. The fund has 100 shares outstanding.

a. What is the net asset value (NAV) of the fund?

NAV = (400 x $7 + 400 x $70)/100 = $30,800/100 = $308.00.

b. If investors expect the price of Fiat shares to increase to $9 and the price of Microsoft
shares to decrease to $55 by the end of the year, what is the expected NAV at the end of
the year?

43
Expected NAV = (400 x $9 + 400 x $55)/100 = $25,600/100 = $256.00, or a decline of
16.88 percent.

c. Assume that the expected price of the Fiat shares is realized at $9. What is the
maximum price decrease that can occur to the Microsoft shares to realize an end-of-
year NAV equal to the NAV estimated in (a)?

(400 x $9)/100 + (400 x PM)/100 = $308.00, implies that PM = $68.00, a decrease of $2.00.

14. What is the difference between open-end and closed-end mutual funds? Which type of
fund tends to be more specialized in asset selection? How does a closed-end fund provide
another source of return from which an investor may either gain or lose?

Open-end funds allow shares to be purchased and redeemed according to investor demand. The
NAV of open-ended funds is determined only by changes in the value of the assets owned. In
closed-end funds, the number of shares of the fund is fixed. If investors need to redeem their
shares, they sell them to another investor. Thus the demand for the fund shares can provide
another source of return for the investors as the market price of the fund may exceed the NAV of
the fund. Closed-end funds, such as real estate investment trusts, tend to be more specialized.

15. Open-end Fund A owns 100 shares of ATT valued at $100 each and 50 shares of Toro
valued at $50 each. Closed-end Fund B owns 75 shares of ATT and 100 shares of Toro.
Each fund has 100 shares of stock outstanding.

a. What are the NAVs of both funds using these prices?

NAVopen-end = (100 x $100 + 50 x $50)/100 = $125.00.

NAVclosed-end = (75 x $100 + 100 x $50)/100 = $125.00.

b. Assume that in one month the price of ATT stock has increased to $105 and the price of
Toro stock has decreased to $45. How do these changes impact the NAV of both
funds? If the funds were purchased at the NAV prices in (a) and sold at month-end,
what would be the realized returns on the investments?

NAVopen-end = (100 x $105 + 50 x $45)/100 = $127.50.


Percentage change in NAV = ($127.50 - $125.00)/$125.00 = 2.00%.

NAVclosed-end = (75 x $105 + 100 x $45)/100 = $123.75.


Percentage change in NAV = ($123.75 - $125.00)/$125.00 = -1.00%.

c. Assume that another 100 shares of ATT are added to Fund A. What is the effect on As
NAV if the stock prices remain unchanged from the original prices?

NAVopen-end = (200 x $100 + 50 x $50)/100 = $225.00.

44
16. What is the difference between a load fund and a no-load fund? Is the argument that load
funds are more closely managed and therefore have higher returns supported by the
evidence presented in Table 5-7?

A load fund charges an up-front fee that often is called a sales charge and is used as a
commission payment for sales representatives. These fees can be as high as 8.5 percent. A no-
load fund does not charge a sales fee, although a small annual fee can be charged to cover certain
administrative expenses. This small fee, which is called a 12b-1 fee, usually ranges between
0.25 and 0.35 percent of assets. According to the data in Table 5-7, the load funds have adjusted
returns that are decreased after the fee is removed. In each case the relative performance ranking
of the fund decreases after the load is subtracted.

17. What is a 12b-1 fee? Suppose you have a choice between a load fund with no annual 12b-1
fee and a no-load fund with a maximum 12b-1 fee. How would the length of your expected
investment horizon, or holding period, influence your choice between these two funds?

The 12b-1 fee is allowed by the SEC to provide assistance in covering administrative expenses
for no-load funds. Thus, in terms of fees and without consideration of time value issues, a 4.00
percent load would be equivalent to the 12b-1 fee for 16 years. This comparison would have to
be adjusted for change in the value of the funds assets over time, since the 12b-1 fee is
administered on an annual basis against the fund value at that time.

18. Suppose an individual invests $10,000 in a load mutual fund for two years. The load fee
entails an up-front commission charge of 4 percent of the amount invested and is deducted
from the original funds invested. In addition, annual fund operating expenses (or 12b-1
fees) are 0.85 percent. The annual fees are charged on the average net asset value invested
in the fund and are recorded at the end of each year. Investments in the fund return 5
percent each year paid on the last day of the year. If the investor reinvests the annual
returns paid on the investment, calculate the annual return on the mutual fund over the two
year investment period.

Annual Return Calculation Based on Text Example 5-4:


Annualized load fee = 4% 2 years = 2.00%
Annual fund operating expense = 0.85%
Total annual cost = 2.85% Annual return = 5.00% - 2.85% = 2.15%

Annual Return Calculation Based on Present Value of Investment:


Initial investment in the fund = $10,000
Front-end load of 4.00% = $400
Total investable funds = $9,600

Investment value at end of year one = $9,600 x 1.05 = $10,080.00


Operating expenses based on average NAV = $9,840 x .0085 = $83.64
Net investable funds for year two = $9,996.36

45
Investment value at end of year two = $9,996.36 x 1.05 = $10,496.18
Operating expenses based on average NAV = $10,246.27 x .0085 = $87.09
Net investment at end of year two = $10,409.09

Average annual compound return:


$10,409.09 = $10,000(1 + g)2 g = 2.025%

19. Who are the primary regulators of the mutual fund industry? How do their regulatory goals
differ from those of other financial institution?

The Securities and Exchange Commission (SEC) is the primary regulator of the mutual fund
industry. The SEC is not concerned with the administration of sound economic monetary policy,
which is part of the goal of the Federal Reserve System, but rather is primarily concerned with
the protection of investors from possible abuses by managers of mutual funds.

Several pieces of legislation have been enacted to clarify and assist this regulatory process.
Under the Securities Act of 1933, mutual funds must file a registration statement with the SEC
and abide by the rules established under the act for the distribution of prospectuses to investors.
The Securities Exchange Act of 1934 establishes antifraud provisions aimed at the accurate
transmission of information to prospective investors. The 1934 act also appointed the National
Association of Securities Dealers to supervise the distribution of mutual fund shares. The
Investment Advisors Act of 1940 regulates the activities of mutual fund advisors, and the
Investment Company Act establishes rules involving fees and charges. The Insider Trading and
Securities Fraud Enforcement Act of 1988 addresses issues of insider trading, and the Market
Reform Act of 1990 provides for the establishment of circuit breakers to halt trading in case of
severe market downturns. Finally, the National Securities Markets Improvement Act of 1996
exempts mutual funds from the regulatory burden of state securities regulators.

46
Chapter Six
The Financial Services Industry: Finance Companies
Chapter Outline

Introduction

Size, Structure, and Competition of the Industry

Balance Sheet and Recent Trends


Consumer Loans
Mortgages
Business Loans
Industry Performance

Regulation

Global Issues

Summary

47
Solutions for End-of-Chapter Questions and Problems: Chapter Six

1. What is the primary function of finance companies? How do finance companies differ
from commercial banks?

The primary function of finance companies is to make loans to individuals and corporations.
Finance companies do not accept deposits, but borrow short- and long-term debt, such as
commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has
caused finance companies to hold more equity than banks for the purpose of signaling solvency
to potential creditors. Finally, finance companies are less regulated than commercial banks, in
part because they do not rely on deposits as a source of funds.

2. What are the three major types of finance companies? To which market segments do these
companies provide service?

The three types of finance companies are (1) sales finance institutions, (2) personal credit
institutions, and (3) business credit institutions. Sales finance companies specialize in making
loans to customers of a particular retailer or manufacturer. An example is General Motors
Acceptance Corporation. Personal credit institutions specialize in making installment loans to
consumers. Business credit institutions provide specialty financing, such as equipment leasing
and factoring, to corporations. Factoring involves the purchasing of accounts receivable at a
discount from corporate customers and assuming the responsibility of collection.

3. What have been the major changes in the accounts receivable balances of finance
companies over the 26-year period from 1977 to 2003?

The amount of consumer and business loans has decreased from 95 percent of assets to 70
percent of assets. Real estate loans and other assets have replaced some of the consumer and
business loans.

4. What are the major types of consumer loans? Why are the rates charged by consumer
finance companies typically higher than those charged by commercial banks?

Consumer loans involve motor vehicle loans and leases, other consumer loans, and securitized
loans, with loans involving motor vehicles involving the largest share. Other consumer loans
include loans for mobile homes, appliances, furniture, etc. The rates charged by finance
companies typically are higher than the rates charged by banks because the customers are
considered to be riskier.

5. Why have home equity loans become popular? What are securitized mortgage assets?

Since the Tax Reform Act of 1986, only loans secured by an individuals home offer tax-
deductible interest for the borrower. Thus these loans are more popular than loans without a tax
deduction, and finance companies as well as banks, credit unions, and savings associations have
been attracted to this loan market.

48
Securitized assets refer to those assets that have been placed in a pool and sold directly into the
capital markets. In the case of mortgages, the resulting capital market asset is a mortgage-
backed security which (1) reflects a small portion of the total pool value; (2) can be traded in the
secondary market; and (3) carries considerably less default or credit risk than the original
mortgage or equity line because of the effects of diversification.

6. What advantages do finance companies have over commercial banks in offering services to
small business customers? What are the major subcategories of business loans? Which
category is largest?

Finance companies have advantages in the following ways: (1) Finance companies are not
subject to regulations that restrict the types of products and services they can offer. (2) Because
they do not accept deposits, they do not have the severe regulatory monitoring. (3) They are
likely to have more product expertise because they generally are subsidiaries of industrial
companies. (4) Finance companies are more willing to take on riskier customers. (5) Finance
companies typically have lower overhead than commercial banks.

The four categories of business loans are (1) retail and wholesale motor vehicle loans and leases,
(2) equipment loans, (3) other business assets, and (4) securitized business assets. Equipment
loans constitute more than half of the business loans.

7. What have been the primary sources of financing for finance companies?

Finance companies have relied primarily on short-term commercial paper and long-term notes
and bonds. While bank credit has been a major source of funds, the use of bank credit has been
declining, as finance companies have become the largest issuer of commercial paper, often with
direct placements to mutual funds and pensions funds.

8. How do finance companies make money? What risks does this process entail? How do
these risks differ for a finance company versus a commercial bank?

Finance companies make a profit by borrowing money at a rate lower than the rate at which they
lend. This is similar to a commercial bank, with the primary difference being the source of
funds, principally deposits for a bank and money and capital market borrowing for a finance
company. The principal risk in relying heavily on commercial paper as a source of financing
involves the continued depth of the commercial paper market. Economic recessions may affect
this market more severely than the effect on deposit drains in the commercial banking sector. In
addition, the riskier asset customers may have a greater impact on the finance companies.

9. Compare Tables 6-1 and 4-7. Which firms have higher ratios of capital to total assets;
finance companies or securities firms? What does this comparison indicate about the
relative strengths of these two types of firms?

Table 6-1 indicates that finance companies had a ratio of capital to total assets of 15.1 percent in
2003. Securities firms (Table 4-7) have 5.7 percent of total capital to total assets, but only 3.8
percent of equity capital to total assets. The higher amount of capital for finance companies

49
serves as a cushion for their own solvency and as a possible signal to the market place regarding
their ability to borrow funds.

10. How does the amount of equity as a percentage of total assets compare for finance
companies and commercial banks? What accounts for this difference?

Finance companies hold relatively more equity than commercial banks. The difference may be
partially due to the fact that the commercial banks have FDIC insured deposits. This insurance
makes the debt safer from the depositors and stockholders perspective. As a result the
commercial banks can take on more debt than the uninsured finance companies.

11. Why do finance companies face less regulation than commercial banks? How does this
advantage translate into performance advantages? What is the major performance
disadvantage?

By not accepting deposits, the need is eliminated for regulators to evaluate the potentially
adverse safety and soundness effects of a finance company failure on the economy. The
performance advantage involves the avoidance of dealing with the heavy regulatory burden, but
the disadvantage is the loss of the use of a relatively cheaper source of deposit funds.

50
Chapter Seven
Risks of Financial Intermediation
Chapter Outline

Introduction

Interest Rate Risk

Market Risk

Credit Risk

Off-Balance-Sheet Risk

Technology and Operational Risk

Foreign Exchange Risk

Country or Sovereign Risk

Liquidity Risk

Insolvency Risk

Other Risks and the Interaction of Risks

Summary

51
Solutions for End-of-Chapter Questions and Problems: Chapter Seven

1. What is the process of asset transformation performed by a financial institution? Why


does this process often lead to the creation of interest rate risk? What is interest rate risk?

Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as
a source of funds. The primary securities purchased by the FI often have maturity and liquidity
characteristics that are different from the secondary securities issued by the FI. For example, a
bank buys medium- to long-term bonds and makes medium-term loans with funds raised by
issuing short-term deposits.

Interest rate risk occurs because the prices and reinvestment income characteristics of long-term
assets react differently to changes in market interest rates than the prices and interest expense
characteristics of short-term deposits. Interest rate risk is the effect on prices (value) and interim
cash flows (interest coupon payment) caused by changes in the level of interest rates during the
life of the financial asset.

2. What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds
long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings
of an increase in the rate of interest? A decrease in the rate of interest?

Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to
finance a long-term fixed-rate asset. This risk occurs when an FI is holding assets with
maturities greater than the maturities of its liabilities. For example, if a bank has a ten-year
fixed-rate loan funded by a 2-year time deposit, the bank faces a risk of borrowing new deposits,
or refinancing, at a higher rate in two years. Thus, interest rate increases would reduce net
interest income. The bank would benefit if the rates fall as the cost of renewing the deposits
would decrease, while the earning rate on the assets would not change. In this case, net interest
income would increase.

3. What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI
funds short-term assets with long-term liabilities, what will be the impact on earnings of a
decrease in the rate of interest? An increase in the rate of interest?

Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have
matured. This risk occurs when an FI holds assets with maturities that are less than the
maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-
rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at
lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives
periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these
periodic cash flows will also be reinvested at the new lower (or higher) interest rates. Besides
the effect on the income statement, this reinvestment risk may cause the realized yields on the
assets to differ from the a priori expected yields.

52
4. The sales literature of a mutual fund claims that the fund has no risk exposure since it
invests exclusively in federal government securities that are free of default risk. Is this
claim true? Explain why or why not.

Although the fund's asset portfolio is comprised of securities with no default risk, the securities
remain exposed to interest rate risk. For example, if interest rates increase, the market value of
the fund's Treasury security portfolio will decrease. Further, if interest rates decrease, the
realized yield on these securities will be less than the expected rate of return because of
reinvestment risk. In either case, investors who liquidate their positions in the fund may sell at a
Net Asset Value (NAV) that is lower than the purchase price.

5. What is economic or market value risk? In what manner is this risk adversely realized in
the economic performance of an FI?

Economic value risk is the exposure to a change in the underlying value of an asset. As interest
rates increase (or decrease), the value of fixed-rate assets decreases (or increases) because of the
discounted present value of the cash flows. To the extent that the change in market value of the
assets differs from the change in market value of the liabilities, the difference is realized in the
market value of the equity of the FI. For example, for most depository FIs, an increase in
interest rates will cause asset values to decrease more than liability values. The difference will
cause the market value, or share price, of equity to decrease.

6. A financial institution has the following balance sheet structure:

Assets Liabilities and Equity


Cash $1,000 Certificate of Deposit $10,000
Bond $10,000 Equity $1,000
Total Assets $11,000 Total Liabilities and Equity $11,000

The bond has a 10-year maturity and a fixed-rate coupon of 10 percent. The certificate of
deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no
additional asset growth.

a. What will be the net interest income (NII) at the end of the first year? Note: Net
interest income equals interest income minus interest expense.

Interest income $1,000 $10,000 x 0.10


Interest expense 600 $10,000 x 0.06
Net interest income (NII) $400

b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent),
what will be the net interest income for the second year? Is the change in NII caused
by reinvestment risk or refinancing risk?

53
Interest income $1,000 $10,000 x 0.10
Interest expense 700 $10,000 x 0.07
Net interest income (NII) $300

The decrease in net interest income is caused by the increase in financing cost without a
corresponding increase in the earnings rate. Thus, the change in NII is caused by
refinancing risk. The increase in market interest rates does not affect the interest income
because the bond has a fixed-rate coupon for ten years. Note: this answer makes no
assumption about reinvesting the first years interest income at the new higher rate.

c. Assuming that market interest rates increase 1 percent, the bond will have a value of
$9,446 at the end of year 1. What will be the market value of the equity for the FI?
Assume that all of the NII in part (a) is used to cover operating expenses or is
distributed as dividends.

Cash $1,000 Certificate of deposit $10,000


Bond $9,446 Equity $ 446
Total assets $10,446 Total liabilities and equity $10,446

d. If market interest rates had decreased 100 basis points by the end of year 1, would the
market value of equity be higher or lower than $1,000? Why?

The market value of the equity would be higher ($1,600) because the value of the bond
would be higher ($10,600) and the value of the CD would remain unchanged.

e. What factors have caused the change in operating performance and market value for
this firm?

The operating performance has been affected by the changes in the market interest rates
that have caused the corresponding changes in interest income, interest expense, and net
interest income. These specific changes have occurred because of the unique maturities of
the fixed-rate assets and fixed-rate liabilities. Similarly, the economic market value of the
firm has changed because of the effect of the changing rates on the market value of the
bond.

7. How does the policy of matching the maturities of assets and liabilities work (a) to
minimize interest rate risk and (b) against the asset-transformation function for FIs?

A policy of maturity matching will allow changes in market interest rates to have approximately
the same effect on both interest income and interest expense. An increase in rates will tend to
increase both income and expense, and a decrease in rates will tend to decrease both income and
expense. The changes in income and expense may not be equal because of different cash flow
characteristics of the assets and liabilities. The asset-transformation function of an FI involves
investing short-term liabilities into long-term assets. Maturity matching clearly works against
successful implementation of this process.

54
8. Corporate bonds usually pay interest semiannually. If a company decided to change from
semiannual to annual interest payments, how would this affect the bonds interest rate risk?

The interest rate risk would increase as the bonds are being paid back more slowly and therefore
the cash flows would be exposed to interest rate changes for a longer period of time. Thus any
change in interest rates would cause a larger inverse change in the value of the bonds.

9. Two 10-year bonds are being considered for an investment that may have to be liquidated
before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon
rate higher than its required rate of return, and the second bond is a zero-coupon bond that
pays only a lump-sum payment after 10 years with no interest over its life. Which bond
would have more interest rate risk? That is, which bonds price would change by a larger
amount for a given change in interest rates? Explain your answer.

The zero-coupon bond would have more interest rate risk. Because the entire cash flow is not
received until the bond matures, the entire cash flow is exposed to interest rate changes over the
entire life of the bond. The cash flows of the coupon-paying bond are returned with periodic
regularity, thus allowing less exposure to interest rate changes. In effect, some of the cash flows
may be received before interest rates change. The effects of interest rate changes on these two
types of assets will be explained in greater detail in the next section of the text.

10. Consider again the two bonds in problem (9). If the investment goal is to leave the assets
untouched until maturity, such as for a childs education or for ones retirement, which of
the two bonds has more interest rate risk? What is the source of this risk?

In this case the coupon-paying bond has more interest rate risk. The zero-coupon bond will
generate exactly the expected return at the time of purchase because no interim cash flows will
be realized. Thus the zero has no reinvestment risk. The coupon-paying bond faces
reinvestment risk each time a coupon payment is received. The results of reinvestment will be
beneficial if interest rates rise, but decreases in interest rate will cause the realized return to be
less than the expected return.

11. A money market mutual fund bought $1,000,000 of two-year Treasury notes six months
ago. During this time, the value of the securities has increased, but for tax reasons the
mutual fund wants to postpone any sale for two more months. What type of risk does the
mutual fund face for the next two months?

The mutual fund faces the risk of interest rates rising and the value of the securities falling.

12. A bank invested $50 million in a two-year asset paying 10 percent interest per annum and
simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum.
What will be the banks net interest income each year if at the end of the first year all
interest rates have increased by 1 percent (100 basis points)?

Net interest income is not affected in the first year, but NII will decrease in the second year.

55
Year 1 Year 2
Interest income $5,000,000 $5,000,000
Interest expense $4,000,000 $4,500,000
Net interest income $1,000,000 $500,000

13. What is market risk? How do the results of this risk surface in the operating performance
of financial institutions? What actions can be taken by FI management to minimize the
effects of this risk?

Market risk is the risk of price changes that affects any firm that trades assets and liabilities. The
risk can surface because of changes in interest rates, exchange rates, or any other prices of
financial assets that are traded rather than held on the balance sheet. Market risk can be
minimized by using appropriate hedging techniques such as futures, options, and swaps, and by
implementing controls that limit the amount of exposure taken by market makers.

14. What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?

Credit risk is the possibility that promised cash flows may not occur or may only partially occur.
FIs that lend money for long periods of time, whether as loans or by buying bonds, are more
susceptible to this risk than those FIs that have short investment horizons. For example, life
insurance companies and depository institutions generally must wait a longer time for returns to
be realized than money market mutual funds and property-casualty insurance companies.

15. What is the difference between firm-specific credit risk and systematic credit risk? How
can an FI alleviate firm-specific credit risk?

Firm-specific credit risk refers to the likelihood that specific individual assets may deteriorate in
quality, while systematic credit risk involves macroeconomic factors that may increase the
default risk of all firms in the economy. Thus, if S&P lowers its rating on IBM stock and if an
investor is holding only this particular stock, she may face significant losses as a result of this
downgrading. However, portfolio theory in finance has shown that firm-specific credit risk can
be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds
well-diversified assets, the FI will face only systematic credit risk that will be affected by the
general condition of the economy. The risks specific to any one customer will not be a
significant portion of the FIs overall credit risk.

16. Many banks and S&Ls that failed in the 1980s had made loans to oil companies in
Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional
economy, and the banks and S&Ls all experienced financial problems. What types of risk
were inherent in the loans that were made by these banks and S&Ls?

The loans in question involved credit risk. Although the geographic risk area covered a large
region of the United States, the risk more closely characterized firm-specific risk than systematic
risk. More extensive diversification by the FIs to other types of industries would have decreased
the amount of financial hardship these institutions had to endure.

56
17. What is the nature of an off-balance-sheet activity? How does an FI benefit from such
activities? Identify the various risks that these activities generate for an FI and explain how
these risks can create varying degrees of financial stress for the FI at a later time.

Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet


investments. The usual benefit of committing to a future activity is the generation of immediate
fee income without the normal recognition of the activity on the balance sheet. As such, these
contingent investments may be exposed to credit risk (if there is some default risk probability),
interest rate risk (if there is some price and/or interest rate sensitivity) and foreign exchange rate
risk (if there is a cross currency commitment).

18. What is technology risk? What is the difference between economies of scale and
economies of scope? How can these economies create benefits for an FI? How can these
economies prove harmful to an FI?

Technology risk occurs when investment in new technologies does not generate the cost savings
expected in the expansion in financial services. Economies of scale occur when the average cost
of production decreases with an expansion in the amount of financial services provided.
Economies of scope occur when an FI is able to lower overall costs by producing new products
with inputs similar to those used for other products. In financial service industries, the use of
data from existing customer databases to assist in providing new service products is an example
of economies of scope.

19. What is the difference between technology risk and operational risk? How does
internationalizing the payments system among banks increase operational risk?

Technology risk refers to the uncertainty surrounding the implementation of new technology in
the operations of an FI. For example, if an FI spends millions on upgrading its computer systems
but is not able to recapture its costs because its productivity has not increased commensurately or
because the technology has already become obsolete, it has invested in a negative NPV
investment in technology.

Operational risk refers to the failure of the back-room support operations necessary to maintain
the smooth functioning of the operation of FIs, including settlement, clearing, and other
transaction-related activities. For example, computerized payment systems such as Fedwire,
CHIPS, and SWIFT allow modern financial intermediaries to transfer funds, securities, and
messages across the world in seconds of real time. This creates the opportunity to engage in
global financial transactions over a short term in an extremely cost-efficient manner. However,
the interdependence of such transactions also creates settlement risk. Typically, any given
transaction leads to other transactions as funds and securities cross the globe. If there is either a
transmittal failure or high-tech fraud affecting any one of the intermediate transactions, this
could cause an unraveling of all subsequent transactions.

20. What two factors provide potential benefits to FIs that expand their asset holdings and
liability funding sources beyond their domestic economies?

57
FIs can realize operational and financial benefits from direct foreign investment and foreign
portfolio investments in two ways. First, the technologies and firms across various economies
differ from each other in terms of growth rates, extent of development, etc. Second, exchange
rate changes may not be perfectly correlated across various economies.

21. What is foreign exchange risk? What does it mean for an FI to be net long in foreign
assets? What does it mean for an FI to be net short in foreign assets? In each case, what
must happen to the foreign exchange rate to cause the FI to suffer losses?

Foreign exchange risk involves the adverse affect on the value of an FIs assets and liabilities
that are located in another country when the exchange rate changes. An FI is net long in foreign
assets when the foreign currency-denominated assets exceed the foreign currency denominated
liabilities. In this case, an FI will suffer potential losses if the domestic currency strengthens
relative to the foreign currency when repayment of the assets will occur in the foreign currency.
An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the
foreign currency denominated assets. In this case, an FI will suffer potential losses if the
domestic currency weakens relative to the foreign currency when repayment of the liabilities will
occur in the domestic currency.

22. If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in
Bern City prefer to be net long or net short in its asset positions? Discuss.

The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The
depreciation of the franc relative to the dollar means that the U.S. FI would pay back the net
liability position with fewer dollars. In other words, the decrease in the foreign assets in dollar
value after conversion will be less than the decrease in the value of the foreign liabilities in dollar
value after conversion.

23. If international capital markets are well integrated and operate efficiently, will banks be
exposed to foreign exchange risk? What are the sources of foreign exchange risk for FIs?

If there are no real or financial barriers to international capital and goods flows, FIs can eliminate
all foreign exchange rate risk exposure. Sources of foreign exchange risk exposure include
international differentials in real prices, cross-country differences in the real rate of interest
(perhaps, as a result of differential rates of time preference), regulatory and government
intervention and restrictions on capital movements, trade barriers, and tariffs.

24. If an FI has the same amount of foreign assets and foreign liabilities in the same currency,
has that FI necessarily reduced to zero the risk involved in these international transactions?
Explain.

Matching the size of the foreign currency book will not eliminate the risk of the international
transactions if the maturities of the assets and liabilities are mismatched. To the extent that the
asset and liabilities are mismatched in terms of maturities, or more importantly durations, the FI
will be exposed to foreign interest rate risk.

58
25. A U.S. insurance company invests $1,000,000 in a private placement of British bonds.
Each bond pays 300 in interest per year for 20 years. If the current exchange rate is
1.7612/$, what is the nature of the insurance companys exchange rate risk? Specifically,
what type of exchange rate movement concerns this insurance company?

In this case, the insurance company is worried about the value of the falling. If this happens,
the insurance company would be able to buy fewer dollars with the received. This would
happen if the exchange rate rose to say 1.88/$ since now it would take more to buy one dollar,
but the bond contract is paying a fixed amount of interest and principal.

26. Assume that a bank has assets located in London worth 150 million on which it earns an
average of 8 percent per year. The bank has 100 million in liabilities on which it pays an
average of 6 percent per year. The current spot rate is 1.50/$.

a. If the exchange rate at the end of the year is 2.00/$, will the dollar have appreciated or
devalued against the mark?

The dollar will have appreciated, or conversely, the will have depreciated.

b. Given the change in the exchange rate, what is the effect in dollars on the net interest
income from the foreign assets and liabilities? Note: The net interest income is interest
income minus interest expense.

Measurement in
Interest received = 12 million
Interest paid = 6 million
Net interest income = 6 million

Measurement in $ before devaluation


Interest received in dollars = $8 million
Interest paid in dollars = $4 million
Net interest income = $4 million

Measurement in $ after devaluation


Interest received in dollars = $6 million
Interest paid in dollars = $3 million
Net interest income = $3 million

c. What is the effect of the exchange rate change on the value of assets and liabilities in
dollars?

The assets were worth $100 million (150m/1.50) before depreciation, but after
devaluation they are worth only $75 million. The liabilities were worth $66.67 million
before depreciation, but they are worth only $50 million after devaluation. Since assets
declined by $25 million and liabilities by $16.67 million, net worth declined by $8.33
million using spot rates at the end of the year.

59
27. Six months ago, Qualitybank, LTD., issued a $100 million, one-year maturity CD
denominated in Euros. On the same date, $60 million was invested in a -denominated
loan and $40 million was invested in a U.S. Treasury bill. The exchange rate six months
ago was 1.7382/$. Assume no repayment of principal, and an exchange rate today of
1.3905/$.

a. What is the current value of the Euro CD principal (in dollars and )?

Today's principal value on the Euro CD is 173.82 and $125m (173.82/1.3905).

b. What is the current value of the Euro-denominated loan principal (in dollars and )?

Today's principal value on the loan is DM104.292 and $75 (104.292/1.3905).

c. What is the current value of the U.S. Treasury bill (in dollars and )?

Today's principal value on the U.S. Treasury bill is $40m and 55.62 (40 x 1.3905),
although for a U.S. bank this does not change in value.

d. What is Qualitybanks profit/loss from this transaction (in dollars and


)?

Qualitybank's loss is $10m or 13.908.

Solution matrix for problem 27:

At Issue Date:
Dollar Transaction Values (in millions) Euro Transaction Values (in millions)
Euro Euro Euro Euro
Loan $60 CD $100 Loan DM104.292 CD DM173.82
U.S T-bill $40 U.S. T-bill DM69.528
$100 $100 DM173.82 DM173.82

Today:
Dollar Transaction Values (in millions) Transaction Values (in millions)
Euro Euro Euro Euro
Loan $75 CD $125 Loan 104.292 CD
173.82
U.S. T-bill $40 U.S. T-bill 55.620
$115 $125 159.912
173.82

28. Suppose you purchase a 10-year, AAA-rated Swiss bond for par that is paying an annual
coupon of 8 percent. The bond has a face value of 1,000 Swiss francs (SF). The spot rate
at the time of purchase is SF1.50/$. At the end of the year, the bond is downgraded to AA
and the yield increases to 10 percent. In addition, the SF appreciates to SF1.35/$.

60
a. What is the loss or gain to a Swiss investor who holds this bond for a year? What
portion of this loss or gain is due to foreign exchange risk? What portion is due to
interest rate risk?

Beginning of the Year


Price of Bond SF 60 * PVAi 6 ,n 10 SF1,000 * PV i6 ,n 10 SF1,000

End of the Year


Price of Bond SF 60 * PVAi 8, n9 SF1,000 * PV i8 ,n 9 SF875 .06

The loss to the Swiss investor (SF875.06 + SF60 - SF1,000)/$1,000 = -6.49 percent. The
entire amount of the loss is due to interest rate risk.

b. What is the loss or gain to a U.S. investor who holds this bond for a year? What
portion of this loss or gain is due to foreign exchange risk? What portion is due to
interest rate risk?

Price at beginning of year = SF1,000/SF1.50 = $666.67


Price at end of year = SF875.06/SF1.35 = $648.19
Interest received at end of year = SF60/SF1.35 = $44.44
Gain to U.S. investor = ($648.19 + $44.44 - $666.67)/$666.67 = +3.89%.

The U.S. investor had an equivalent loss of 6.49 percent from interest rate risk, but he had a
gain of 10.38 percent (3.89 - (-6.49)) from foreign exchange risk. If the Swiss franc had
depreciated, the loss to the U.S. investor would have been larger than 6.49 percent.

29. What is country or sovereign risk? What remedy does an FI realistically have in the event
of a collapsing country or currency?

Country risk involves the interference of a foreign government in the transmission of funds
transfer to repay a debt by a foreign borrower. A lender FI has very little recourse in this
situation unless the FI is able to restructure the debt or demonstrate influence over the future
supply of funds to the country in question. This influence likely would involve significant
working relationships with the IMF and the World Bank.

30. Characterize the risk exposure(s) of the following FI transactions by choosing one or more
of the risk types listed below:

a. Interest rate risk d. Technology risk


b. Credit risk e. Foreign exchange rate risk
c. Off-balance-sheet risk f. Country or sovereign risk

(1) A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-
year certificates of deposit. a, b
(2) An insurance company invests its policy premiums in a long-term municipal bond
portfolio. a, b

61
(3) A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to
a British entrepreneur. b, e, f
(4) A Japanese bank acquires an Austrian bank to facilitate clearing operations.
a, b, c, d, e, f
(5) A mutual fund completely hedges its interest rate risk exposure using forward
contingent contracts. b, c
(6) A bond dealer uses his own equity to buy Mexican debt on the less-developed country
(LDC) bond market. a, b, e, f
(7) A securities firm sells a package of mortgage loans as mortgage backed securities.
A, b, c

31. Consider these four types of risks: credit, foreign exchange, market, and sovereign. These
risks can be separated into two pairs of risk types in which each pair consists of two related
risk types, with one being a subset of the other. How would you pair off the risk types, and
which risk type may be considered a subset of another?

Credit risk and sovereign risk comprise one pair, while FX and market risk make up the other.
Sovereign risk is a type of credit risk in that one reason why a loan may default is because of
political upheaval in the country in which the borrower resides. FX risk is a type of market risk
in that one reason why the market value of an outstanding loan or security may change is due to
a change in exchange rates.

32. What is liquidity risk? What routine operating factors allow FIs to deal with this risk in
times of normal economic activity? What market reality can create severe financial
difficulty for an FI in times of extreme liquidity crises?

Liquidity risk is the uncertainty that an FI may need to obtain large amounts of cash to meet the
withdrawals of depositors or other liability claimants. In times of normal economic activity,
depository FIs meet cash withdrawals by accepting new deposits and borrowing funds in the
short-term money markets. However, in times of harsh liquidity crises, the FI may need to sell
assets at significant losses in order to generate cash quickly.

33. Why can insolvency risk be classified as a consequence or outcome of any or all of the
other types of risks?

Insolvency risk involves the shortfall of capital in times when the operating performance of the
institution generates accounting losses. These losses may be the result of one or more of interest
rate, market, credit, liquidity, sovereign, foreign exchange, technological, and off-balance-sheet
risks.

34. Discuss the interrelationships among the different sources of bank risk exposure. Why
would the construction of a bank risk-management model to measure and manage only one
type of risk be incomplete?

Measuring each source of bank risk exposure individually creates the false impression that they
are independent of each other. For example, the interest rate risk exposure of a bank could be

62
reduced by requiring bank customers to take on more interest rate risk exposure through the use
of floating rate products. However, this reduction in bank risk may be obtained only at the
possible expense of increased credit risk. That is, customers experiencing losses resulting from
unanticipated interest rate changes may be forced into insolvency, thereby increasing bank
default risk. Similarly, off-balance sheet risk encompasses several risks since off-balance sheet
contingent contracts typically have credit risk and interest rate risk as well as currency risk.
Moreover, the failure of collection and payment systems may lead corporate customers into
bankruptcy. Thus, technology risk may influence the credit risk of FIs.

As a result of these interdependencies, FIs have focused on developing sophisticated models that
attempt to measure all of the risks faced by the FI at any point in time.

63
Chapter Eight
Interest Rate Risk I
Chapter Outline

Introduction

The Central Bank and Interest Rate Risk

The Repricing Model


Rate-Sensitive Assets
Rate-Sensitive Liabilities
Equal Changes in Rates on RSAs and RSLs
Unequal Changes in Rates on RSAs and RSLs

Weaknesses of the Repricing Model


Market Value Effects
Overaggregation
The Problem of Runoffs
Cash Flows from Off-Balance Sheet Activities

The Maturity Model


The Maturity Model with a Portfolio of Assets and Liabilities

Weakness of the Maturity Model

Summary

Appendix 8A: Term Structure of Interest Rates


Unbiased Expectations Theory
Liquidity Premium Theory
Market Segmentation Theory

1
Solutions for End-of-Chapter Questions and Problems: Chapter Eight

1. What was the impact on interest rates of the borrowed reserves targeting regime used by the Federal
Reserve from 1982 to 1993?

The volatility of interest rates was significantly lower than under the nonborrowed reserves target regime
used in the three years immediately prior to 1982. Figure 8-1 indicates that both the level and volatility
of interest rates declined even further after 1993 when the Fed decided that it would target primarily the
fed funds rate as a guide for monetary policy.

2. How has the increased level of financial market integration affected interest rates?

Increased financial market integration, or globalization, increases the speed with which interest rate
changes and volatility are transmitted among countries. The result of this quickening of global economic
adjustment is to increase the difficulty and uncertainty faced by the Federal Reserve as it attempts to
manage economic activity within the U.S. Further, because FIs have become increasingly more global in
their activities, any change in interest rate levels or volatility caused by Federal Reserve actions more
quickly creates additional interest rate risk issues for these companies.

3. 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 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.

4. 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?

The maturity bucket is the time window over which the dollar amounts of assets and liabilities are
measured. The length of the repricing period determines which of the securities in a portfolio are rate-
sensitive. The longer the repricing period, the more securities either mature or need to be repriced, and,
therefore, the more the interest rate exposure. An excessively short repricing period omits consideration
of the interest rate risk exposure of assets and liabilities are that repriced in the period immediately
following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet.
An excessively long repricing period includes many securities that are repriced at different times within
the repricing period, thereby overstating the rate sensitivity of the balance sheet.

2
5. Calculate the repricing gap and the impact on net interest income of a 1 percent increase in interest
rates for each of the following positions:

Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.

Repricing gap = RSA - RSL = $200 - $100 million = +$100 million.


NII = ($100 million)(.01) = +$1.0 million, or $1,000,000.

Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million.

Repricing gap = RSA - RSL = $100 - $150 million = -$50 million.


NII = (-$50 million)(.01) = -$0.5 million, or -$500,000.

Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million.

Repricing gap = RSA - RSL = $150 - $140 million = +$10 million.


NII = ($10 million)(.01) = +$0.1 million, or $100,000.

a. Calculate the impact on net interest income on each of the above situations assuming a 1 percent
decrease in interest rates.

NII = ($100 million)(-.01) = -$1.0 million, or -$1,000,000.

NII = (-$50 million)(-.01) = +$0.5 million, or $500,000.

NII = ($10 million)(-.01) = -$0.1 million, or -$100,000.

b. What conclusion can you draw about the repricing model from these results?

The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap) while the FI
in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest rate risk
exposure since the absolute value of the repricing gap is the lowest, while the opposite is true for
part (1).

6. What are the reasons for not including demand deposits as rate-sensitive liabilities in the repricing
analysis for a commercial bank? What is the subtle, but potentially strong, reason for including
demand deposits in the total of rate-sensitive liabilities? Can the same argument be made for
passbook savings accounts?

The regulatory rate available on demand deposit accounts is zero. Although many banks are able to offer
NOW accounts on which interest can be paid, this interest rate seldom is changed and thus the accounts
are not really sensitive. However, demand deposit accounts do pay implicit interest in the form of not
charging fully for checking and other services. Further, when market interest rates rise, customers draw
down their DDAs, which may cause the bank to use higher cost sources of funds. The same or similar
arguments can be made for passbook savings accounts.

7. What is the gap ratio? What is the value of this ratio to interest rate risk managers and regulators?

The gap ratio is the ratio of the cumulative gap position to the total assets of the bank. The cumulative
gap position is the sum of the individual gaps over several time buckets. The value of this ratio is that it
tells the direction of the interest rate exposure and the scale of that exposure relative to the size of the
bank.

3
8. Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test?

91-day 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

9. Consider the following balance sheet for WatchoverU Savings, Inc. (in millions):

Assets Liabilities and Equity


Floating-rate mortgages Demand deposits
(currently 10% annually) $50 (currently 6% annually) $70
30-year fixed-rate loans Time deposits
(currently 7% annually) $50 (currently 6% annually $20
Equity $10
Total Assets $100 Total Liabilities & Equity $100

a. What is WatchoverUs expected net interest income at year-end?

Current expected interest income: $5m + $3.5m = $8.5m.


Expected interest expense: $4.2m + $1.2m = $5.4m.
Expected net interest income: $8.5m - $5.4m = $3.1m.

b. What will be the net interest income at year-end if interest rates rise by 2 percent?

After the 200 basis point interest rate increase, net interest income declines to:
50(0.12) + 50(0.07) - 70(0.08) - 20(.06) = $9.5m - $6.8m = $2.7m, 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?

Wachovias' repricing or funding gap is $50m - $70m = -$20m. The change in net interest income
using the funding gap model is (-$20m)(0.02) = -$.4m.

d. What will be the net interest income at year-end if interest rates increase 200 basis points on
assets, but only 100 basis points on liabilities? Is it reasonable for changes in interest rates to
affect balance sheet in an uneven manner? Why?

After the unbalanced rate increase, net interest income will be 50(0.12) + 50(0.07) - 70(0.07) -
20(.06) = $9.5m - $6.1m = $3.4m, an increase of $0.3m. It is not uncommon for interest rates to
adjust in an uneven manner over two sides of the balance sheet because 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.

10. 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 models analysis?

4
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
unsuspectedly. To the extent that either of these amounts is significantly greater than expected, the
estimated interest rate sensitivity of the bank will be in error.

11. Use the following information about a hypothetical government security dealer named M.P. Jorgan.
Market yields are in parenthesis, and amounts are in millions.

Assets Liabilities and Equity


Cash $10 Overnight Repos $170
1 month T-bills (7.05%) 75 Subordinated debt
3 month T-bills (7.25%) 75 7-year fixed rate (8.55% 150
2 year T-notes (7.50%) 50
8 year T-notes (8.96%) 100
5 year munis (floating rate)
(8.20% reset every 6 months) 25 Equity 15
Total Assets $335 Total Liabilities & Equity $335

a. What is the funding or repricing gap if the planning period is 30 days? 91 days? 2 years?
Recall that cash is a noninterest-earning asset.

Funding or repricing gap using a 30-day planning period = 75 - 170 = -$95 million.
Funding gap using a 91-day planning period = (75 + 75) - 170 = -$20 million.
Funding gap using a two-year planning period = (75 + 75 + 50 + 25) - 170 = +$55 million.

b. What is the impact over the next 30 days on net interest income if all interest rates rise 50 basis
points? Decrease 75 basis points?

Net interest income will decline by $475,000. NII = FG(R) = -95(.005) = $0.475m.
Net interest income will increase by $712,500. NII = FG(R) = -95(.0075) = $0.7125m.

c. The following one-year runoffs are expected: $10 million for two-year T-notes, and $20 million
for eight-year T-notes. What is the one-year repricing gap?

Funding or repricing gap over the 1-year planning period = (75 + 75 + 10 + 20 + 25) - 170 = +$35
million.

d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates
rise 50 basis points? Decrease 75 basis points?

5
Net interest income will increase by $175,000. NII = FG(R) = 35(0.005) = $0.175m.
Net interest income will decrease by $262,500, NII = FG(R) = 35(-0.0075) =
-$0.2625m.

12. What is the difference between book value accounting and market value accounting? How do
interest rate changes affect the value of bank assets and liabilities under the two methods? What is
marking to market?

Book value accounting reports assets and liabilities at the original issue values. Current market values
may be different from book values because they reflect current market conditions, such as interest rates or
prices. This is especially a problem if an asset or liability has to be liquidated immediately. If the asset or
liability is held until maturity, then the reporting of book values does not pose a problem.

For an FI, a major factor affecting asset and liability values is interest rate changes. If interest rates
increase, the value of both loans (assets) and deposits and debt (liabilities) fall. If assets and liabilities are
held until maturity, it does not affect the book valuation of the FI. However, if deposits or loans have to
be refinanced, then market value accounting presents a better picture of the condition of the FI.
The process by which changes in the economic value of assets and liabilities are accounted is called
marking to market. The changes can be beneficial as well as detrimental to the total economic health of
the FI.

13. Why is it important to use market values as opposed to book values when evaluating the net worth
of an FI? What are some of the advantages of using book values as opposed to market values?

Book values represent historical costs of securities purchased, loans made, and liabilities sold. They do
not reflect current values as determined by market values. Effective financial decision-making requires
up-to-date information that incorporates current expectations about future events. Market values provide
the best estimate of the present condition of an FI and serve as an effective signal to managers for future
strategies.

Book values are clearly measured and not subject to valuation errors, unlike market values. Moreover, if
the FI intends to hold the security until maturity, then the security's current liquidation value will not be
relevant. That is, the paper gains and losses resulting from market value changes will never be realized if
the FI holds the security until maturity. Thus, the changes in market value will not impact the FI's
profitability unless the security is sold prior to maturity.

14. Consider a $1,000 bond with a fixed-rate 10 percent annual coupon (Cpn %) and a maturity (N) of
10 years. The bond currently is trading to a market yield to maturity (YTM) of 10 percent.
Complete the following table.

From Par, $ From Par, %


N Cpn % YTM Price Change in Price Change in Price
8 10% 9% $1,055.35 $55.35 5.535%
9 10% 9% $1,059.95 $59.95 5.995%

10 10% 9% $1,064.18 $64.18 6.418%


10 10% 10% $1,000.00
10 10% 11% $941.11 -$58.89 -5.889%

11 10% 11% $937.93 -$62.07 -6.207%


12 10% 11% $935.07 -$64.93 -6.493%

Use this information to verify the principles of interest rate-price relationships for fixed-rate
financial assets.

6
Rule One: Interest rates and prices of fixed-rate financial assets move inversely. See the change in
price from $1,000 to $941.11 for the change in interest rates from 10 percent to 11 percent, or from
$1,000 to $1,064.18 when rates change from 10 percent to 9 percent.

Rule Two: The longer is the maturity of a fixed-income financial asset, the greater is the change in
price for a given change in interest rates. A change in rates from 10 percent to 11 percent has
caused the 10-year bond to decrease in value $58.89, but the 11-year bond will decrease in value
$62.07, and the 12-year bond will decrease $64.93.

Rule Three: The change in value of longer-term fixed-rate financial assets increases at a decreasing
rate. For the increase in rates from 10 percent to 11 percent, the difference in the change in price
between the 10-year and 11-year assets is $3.18, while the difference in the change in price between
the 11-year and 12-year assets is $2.86.

Rule Four: Although not mentioned in the text, for a given percentage () change in interest rates,
the increase in price for a decrease in rates is greater than the decrease in value for an increase in
rates. Thus for rates decreasing from 10 percent to 9 percent, the 10-year bond increases $64.18.
But for rates increasing from 10 percent to 11 percent, the 10-year bond decreases $58.89.

15. Consider a 12-year, 12 percent annual coupon bond with a required return of 10 percent. The bond
has a face value of $1,000.

a. What is the price of the bond?

PV = $120*PVIFAi=10%,n=12 + $1,000*PVIFi=10%,n=12 = $1,136.27

b. If interest rates rise to 11 percent, what is the price of the bond?

PV = $120*PVIFAi=11%,n=12 + $1,000*PVIFi=11%,n=12 = $1,064.92

c. What has been the percentage change in price?

7
P = ($1,064.92 - $1,136.27)/$1,136.27 = -0.0628 or 6.28 percent.

d. Repeat parts (a), (b), and (c) for a 16-year bond.

PV = $120*PVIFAi=10%,n=16 + $1,000*PVIFi=10%,n=16 = $1,156.47


PV = $120*PVIFAi=11%,n=16 + $1,000*PVIFi=11%,n=16 = $1,073.79
P = ($1,073.79 - $1,156.47)/$1,156.47 = -0.0715 or 7.15 percent.

e. What do the respective changes in bond prices indicate?

For the same change in interest rates, longer-term fixed-rate assets have a greater change in price.

16. Consider a five-year, 15 percent annual coupon bond with a face value of $1,000. The bond is
trading at a market yield to maturity of 12 percent.

a. What is the price of the bond?

PV = $150*PVIFAi=12%,n=5 + $1,000*PVIFi=12%,n=5 = $1,108.14


b. If the market yield to maturity increases 1 percent, what will be the bonds new price?

PV = $150*PVIFAi=13%,n=5 + $1,000*PVIFi=13%,n=5 = $1,070.34

c. Using your answers to parts (a) and (b), what is the percentage change in the bonds price as a
result of the 1 percent increase in interest rates?

P = ($1,070.34 - $1,108.14)/$1,108.14 = -0.0341 or 3.41 percent.

d. Repeat parts (b) and (c) assuming a 1 percent decrease in interest rates.

PV = $150*PVIFAi=11%,n=5 + $1,000*PVIFi=11%,n=5 = $1,147.84


P = ($1,147.84 - $1,108.14)/$1,108.14 = 0.0358 or 3.58 percent

e. What do the differences in your answers indicate about the rate-price relationships of fixed-rate
assets?

For a given percentage change in interest rates, the absolute value of the increase in price caused by
a decrease in rates is greater than the absolute value of the decrease in price caused by an increase
in rates.

17. What is maturity gap? How can the maturity model be used to immunize an FIs portfolio? What
is the critical requirement to allow maturity matching to have some success in immunizing the
balance sheet of an FI?

Maturity gap is the difference between the average maturity of assets and liabilities. If the maturity gap is
zero, it is possible to immunize the portfolio, so that changes in interest rates will result in equal but
offsetting changes in the value of assets and liabilities and net interest income. Thus, if interest rates
increase (decrease), the fall (rise) in the value of the assets will be offset by a perfect fall (rise) in the
value of the liabilities. The critical assumption is that the timing of the cash flows on the assets and
liabilities must be the same.

18. Nearby Bank has the following balance sheet (in millions):

Assets Liabilities and Equity


Cash $60 Demand deposits $140
8
5-year treasury notes $60 1-year Certificates of Deposit $160
30-year mortgages $200 Equity $20
Total Assets $320 Total Liabilities and Equity $320

What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or
decrease in interest rates? Explain why?

MA = [0*20 + 5*60 + 200*30]/320 = 19.69 years, and ML = [0*140 + 1*160]/300 = 0.533. Therefore the
maturity gap = MGAP = 19.69 0.533 = 19.16 years. Nearby bank is exposed to an increase in interest
rates. If rates rise, the value of assets will decrease much more than the value of liabilities.

19. County Bank has the following market value balance sheet (in millions, annual rates):

Assets Liabilities and Equity


Cash $20 Demand deposits $100
15-year commercial loan @ 10% 5-year CDs @ 6% interest,
interest, balloon payment $160 balloon payment $210
30-year Mortgages @ 8% interest, 20-year debentures @ 7% interest $120
monthly amortizing $300 Equity $50
Total Assets $480 Total Liabilities & Equity $480

a. What is the maturity gap for County Bank?

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


ML = [0*100 + 5*210 + 20*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 = $16*PVIFAn=15, i=11% + $160*PVIFn=15,i=11% = $148.49
Mortgages = $2.201,294*PVIFAn=360,i=9% = $273.581
MA = [0*20 + 148.49*15 + 273.581*30]/(20 + 148.49 + 273.581) = 23.60 years

The value and average maturity of the liabilities will be:


Demand deposits = $100
CDs = $12.60*PVIFAn=5,i=7% + $210*PVIFn=5,i=7% = $201.39
Debentures = $8.4*PVIFAn=20,i=8% + $120*PVIFn=20,i=8% = $108.22
ML = [0*100 + 5*201.39 + 20*108.22]/(100 + 201.39 + 108.22) = 7.74 years

The maturity gap = MGAP = 23.60 7.74 = 15.86 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.

c. What will happen to the market value of the equity?

The market value of the assets has decreased from $480 to $442.071, or $37.929. The market value
of the liabilities has decreased from $430 to $409.61, or $20.69. Therefore the market value of the
equity will decrease by $37.929 - $20.69 = $17.239, or 34.48 percent.

d. If interest rates increased by 2 percent, would the bank be solvent?

9
The value of the assets would decrease to $409.04, and the value of the liabilities would decrease to
$391.32. Therefore the value of the equity would be $17.72. Although the bank remains solvent,
nearly 65 percent of the equity has eroded because of the increase in interest rates.

20. Given that bank balance sheets typically are accounted in book value terms, why should the
regulators or anyone else be concerned about how interest rates affect the market values of assets
and liabilities?

The solvency of the balance sheet is an important variable to creditors of the bank. If the capital position
of the bank decreases to near zero, creditors may not be willing to provide funding for the bank, and the
bank may need assistance from the regulators, or may even fail. Thus any change in the market value of
assets or liabilities that is caused by changes in the level of interest rate changes is of concern to
regulators.

21. 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 banks maturity gap to take advantage of this anticipated
increase? What if the manager believed rates would 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 (or duration gap) is positive, the bank manager will want to shorten the maturity gap. If the
repricing gap is negative, the manager will want to move it towards zero or positive. If rates are expected
to decrease, the manager should reverse these strategies. Changing the maturity, duration, or funding
gaps 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. Later in the text, methods of achieving the same results using derivatives will be explored.

22. Consumer Bank has $20 million in cash and a $180 million loan portfolio. The assets are funded
with demand deposits of $18 million, a $162 million CD and $20 million in equity. The loan
portfolio has a maturity of 2 years, earns interest at the annual rate of 7 percent, and is amortized
monthly. The bank pays 7 percent annual interest on the CD, but the interest will not be paid until
the CD matures at the end of 2 years.

a. What is the maturity gap for Consumer Bank?

MA = [0*$20 + 2*$180]/$200 = 1.80 years


ML = [0*$18 + 2*$162]/$180 = 1.80 years
MGAP = 1.80 1.80 = 0 years.

b. Is Consumer Bank immunized or protected against changes in interest rates? Why or why not?

It is tempting to conclude that the bank is immunized because the maturity gap is zero. However,
the cash flow stream for the loan and the cash flow stream for the CD are different because the loan
amortizes monthly and the CD pays annual interest on the CD. Thus any change in interest rates
will affect the earning power of the loan more than the interest cost of the CD.

c. Does Consumer Bank face interest rate risk? That is, if market interest rates increase or
decrease 1 percent, what happens to the value of the equity?

The bank does face interest rate risk. If market rates increase 1 percent, the value of the cash and
demand deposits does not change. However, the value of the loan will decrease to $178.19, and the
value of the CD will fall to $159.01. Thus the value of the equity will be ($178.19 + $20 - $18 -
$159.01) = $21.18. In this case the increase in interest rates causes the market value of equity to
increase because of the reinvestment opportunities on the loan payments.

10
If market rates decrease 1 percent, the value of the loan increases to $181.84, and the value of the
CD increases to $165.07. Thus the value of the equity decreases to $18.77.

d. How can a decrease in interest rates create interest rate risk?

The amortized loan payments would be reinvested at lower rates. Thus even though interest rates
have decreased, the different cash flow patterns of the loan and the CD have caused interest rate
risk.

23. FI International holds seven-year Acme International bonds and two-year Beta Corporation bonds.
The Acme bonds are yielding 12 percent and the Beta bonds are yielding 14 percent under current
market conditions.

a. What is the weighted-average maturity of FIs bond portfolio if 40 percent is in Acme bonds
and 60 percent is in Beta bonds?

Average maturity = 0.40 x 7 years + 0.60 x 2 years = 4 years

b. What proportion of Acme and Beta bonds should be held to have a weighted-average yield of
13.5 percent?

Let X*(0.12) + (1 - X)*(0.14) = 0.135. Solving for X, we get 25 percent. In order to get an average
yield of 13.5 percent, we need to hold 25 percent of Acme and 75 percent of Beta.

c. What will be the weighted-average maturity of the bond portfolio if the weighted-average yield
is realized?

The average maturity of the portfolio will decrease to 0.25 x 7 + 0.75 x 2 = 3.25 years.

24. An insurance company has invested in the following fixed-income securities: (a) $10,000,000 of 5-
year Treasury notes paying 5 percent interest and selling at par value, (b) $5,800,000 of 10-year
bonds paying 7 percent interest with a par value of $6,000,000, and (c) $6,200,000 of 20-year
subordinated debentures paying 9 percent interest with a par value of $6,000,000.

a. What is the weighted-average maturity of this portfolio of assets?

MA = [5*$10 + 10*$5.8 + 20*$6.2]/$22 = 232/22 = 10.55 years

b. If interest rates change so that the yields on all of the securities decrease 1 percent, how does the
weighted-average maturity of the portfolio change?

To determine the weighted-average maturity of the portfolio for a rate decrease of 1 percent, the
new value of each security must be determined. This calculation will require knowing the YTM of
each security before the rate change.

T-notes are selling at par, so the YTM = 5 percent. Therefore, the new value will be
PV = $500,000*PVIFAn=5,i=4% + $10,000,000*PVIFn=5,i=4% = $10,445,182.

10-year bonds: Par = $6,000,000, PV = $5,800,000, Cpn = 7 percent YTM = 7.485%. The new
PV = $420,000*PVIFAn=10,i=6.485% + $6,000,000*PVIFn=10,i=6.485% = $6,222,290.

Debentures: Par = $6,000,000, PV = $6,200,000, Cpn = 9 percent 8.644 percent. The new PV =
$540,000*PVIFAn=20,i=7.644% + $6,000,000*PVIF n=20,i=7.644 = $6,820,418.

11
The total value of the assets after the change in rates will be $23,487,890, and the weighted-average
maturity will be [5*10,445,182 + 10*6,222,290 + 20*6,820,418]/23,487,890 =
250,857,170/23,487,890 = 10.68 years.

c. Explain the changes in the maturity values if the yields increase by 1 percent.

When interest rates increase 1 percent, the value of the T-note is $9,578,764, the value of the 10-
year bond is $5,414,993, and the value of the debenture is $5,662,882, and the new value of the
assets is $20,656,639. The weighted-average maturity is 10.42 years.

d. Assume that the insurance company has no other assets. What will be the effect on the market
value of the companys equity if the interest rate changes in (b) and (c) occur?

Assuming that the company is financed entirely with equity, the market value will increase
$1,487,890 when interest rates decrease 1 percent, and the market value will decrease $1,343,361
when rates increase 1 percent. Notice that for the same absolute rate change, the increase in value is
greater than the decrease in value (rule number four in problem 12.)

12
25. The following is a simplified FI balance sheet:

Assets Liabilities and Equity


Loans $1,000 Deposits $850
0 Equity $150
Total Assets $1,000 Total Liabilities & Equity $1,000

The average maturity of loans is four years, and the average maturity of deposits is two years.
Assume loan and deposit balances are reported as book value, zero-coupon items.

a. Assume that interest rates on both loans and deposits are 9 percent. What is the market value of
equity?

The value of loans = $1,000/(1.09)4 = $708.43, and the value of deposits = $850/(1.09)2 = $715.43.
The net worth = $708.43 - $715.43 = -$7.0028. (That is, net worth is negative.)

b. What must be the interest rate on deposits to force the market value of equity to be zero? What
economic market conditions must exist to make this situation possible?

In this case the deposit value should equal the loan value. Thus, $850/(1 + x)2 = $708.43. Solving
for x, we get 9.5374%. That is, deposit rates will have to increase more because they have a shorter
maturity. Note: for those using calculators, you need to compute I/YEAR after entering 850 = FV, -
708.43 = PV, 0 = PMT, 2 = N.

c. Assume that interest rates on both loans and deposits are 9 percent. What must be the average
maturity of deposits for the market value of equity to be zero?

In this case, we need to solve the equation in part (b) for N. The result is 2.1141 years. If interest
rates remain at 9 percent, then the average maturity of deposits has to be higher in order to match
the value of a 4-year loan.

26. Gunnison Insurance has reported the following balance sheet (in thousands):

Assets Liabilities and Equity


2-year Treasury note $175 1-year commercial paper $135
15-year munis $165 5-year note $160
Equity $45
Total Assets $340 Total Liabilities & Equity $340

All securities are selling at par equal to book value. The two-year notes are yielding 5 percent, and
the 15-year munis are yielding 9 percent. The one-year commercial paper pays 4.5 percent, and the
five-year notes pay 8 percent. All instruments pay interest annually.

a. What is the weighted-average maturity of the assets for Gunnison?

MA = [2*$175 + 15*$165]/$340 = 8.31 years

b. What is the weighted-average maturity of the liabilities for Gunnison?

ML = [1*$135 + 5*$160]/$295 = 3.17 years

c. What is the maturity gap for Gunnison?

MGAP = 8.31- 3.17 = 5.14 years

13
d. What does your answer to part (c) imply about the interest rate exposure of Gunnison
Insurance?

Gunnison Insurance is exposed to interest rate risk. If interest rates rise, net worth will decline
because the average maturity of the assets is higher than the average maturity of the liabilities. The
opposite holds true if interest rates fall (That is, net worth will increase.)

e. Calculate the values of all four securities of Gunnison Insurances balance sheet assuming that
all interest rates increase 2 percent. What is the dollar change in the total asset and total liability
values? What is the percentage change in these values?

T-notes: PV = 8.75*PVIFAi=7%,n=2 + 175*PVIFi=7%,n=2 = $168.67


Munis: PV = 14.85*PVIFAi=11%,n=15 + 165*PVIFi=11%,n=15 = $141.27
Commercial Paper: PV = 6.075*PVIFAi=6.5%,n=1 + 135*PVIFi=6.5%,n=1 = $132.46
Note: PV = 12.80*PVIFAi=10%,n=5 + 160*PVIFi=10%,n=5 = $147.87

Total assets = $168.67 + $141.27 = $309.94 A = -$30.06 or -8.84 percent change


Total liabilities = $132.46 + $147.87 = $280.33 L = -$14.67 or -4.97 percent change

f. What is the dollar impact on the market value of equity for Gunnison? What is the percentage
change in the value of the equity?

E = A - L = -$30.06 (-$14.67) = -$15.39 -34.2 percent

g. What would be the impact on Gunnisons market value of equity if the liabilities paid interest
semiannually instead of annually?

The value of liabilities will be lower with semi-annual compounding, increasing the value of net
worth. The one-year CP will decline in value to $132.426. The five-year note will decline in value
to $147.645. The value of equity will increase to $29.869 = ($168.67 + $141.27) - ($132.426 +
$147.645).

27. Scandia Bank has issued a one-year, $1million CD paying 5.75 percent to fund a one-year loan
paying an interest rate of 6 percent. The principal of the loan will be paid in two installments,
$500,000 in 6 months and the balance at the end of the year.

a. What is the maturity gap of Scandia Bank? According to the maturity model, what does this
maturity gap imply about the interest rate risk exposure faced by the bank?

The maturity gap is 1 year 1 year = 0. The maturity gap model would state that the portfolio is
immunized against changes in interest rates because assets and liabilities are of equal maturity.

b. What is the expected net interest income at the end of the year?

Principal received in six months $500,000


Interest received in six months (.03 x $1,000,000) $30,000
Total $530,000

Principal received at the end of the year $500,000


Interest received at the end of the year (.03 x $500,000) $15,000
Future value of interest received in six months ($530,000 x 1.03*) $545,900
Total principal and interest received $1,060,900
Principal and interest paid on deposits ($1,000,000 x 0.0575) $1,057,500
Net interest income received $3,400
14
* It is assumed that the money will be reinvested at current loan rates. Note that the principal is also
included in the analysis because interest expense is based on $1,000,000.

c. What would be the effect on annual net interest income of a 2 percent interest rate increase that
occurred immediately after the loan was made? What would be the effect of a 2 percent
decrease in rates?

If interest rates increase 2 percent, then the reinvestment benefits of cash flows in six months will
be higher:

Principal received in six months $500,000


Interest received in six months (.03 x $1,000,000) $30,000
Total $530,000

Principal received at the end of the year $500,000


Interest received at the end of the year (.03 x $500,000) $15,000
Future value of interest received in six months ($530,000 x 1.04) $551,200
Total principal and interest received $1,066,200

Principal and interest paid on deposits ($1,000,000 x 0.0575) $1,057,500


Net interest income received $8,700

If interest rates decrease by 2 percent, then reinvestment income is reduced.

Principal received in six months $500,000


Interest received in six months (.03 x $1,000,000) $30,000
Total $530,000

Principal received at the end of the year $500,000


Interest received at the end of the year (.03 x $500,000) $15,000
Future value of interest received in six months ($530,000 x 1.02) $540,600
Total principal and interest received $1,055,600

Principal and interest paid on deposits ($1,000,000 x 0.0575) $1,057,500


Net income received $-1,900

d. What do these results indicate about the maturity models ability to immunize portfolios against
interest rate exposure?

The results indicate that just matching assets and liabilities by maturity is not sufficient to immunize
a portfolio. If the timing of the cash flows within a period is different for assets and liabilities, the
effects of interest rate changes are different. For a truly effective immunization strategy, one also
needs to account for the timing of cash flows.

28. EDF Bank has a very simple balance sheet. Assets consist of a two-year, $1 million loan that pays
an interest rate of LIBOR plus 4 percent annually. The loan is funded with a two-year deposit on
which the bank pays LIBOR plus 3.5 percent interest annually. LIBOR currently is 4 percent, and
both the loan and deposit principal will be paid at maturity.

a. What is the maturity gap of this balance sheet?

Maturity gap = 2 - 2 = 0 years

b. What is the expected net interest income in year 1 and year 2?


15
Interest received in year 1 $80,000 Interest received in year 2 $80,000
Interest paid in year 1 $75,000 Interest paid in year 2 $75,000
Net interest income in year 1 $5,000 Net interest income in year 2 $5,000

c. Immediately prior to the beginning of year 2, LIBOR rates increased to 6 percent. What is the
expected net interest income in year 2? What would be the effect on net interest income of a 2
percent decrease in LIBOR?

Year 2: If interest rates increase 2 percent Year 2: If interest rates decrease 2 percent
Interest received in year 2 $100,000 Interest received in year 2 $60,000
Interest paid in year 2 $95,000 Interest paid in year 2 $55,000
Net interest income in year 2 $5,000 Net interest income in year 2 $5,000

d. How would your results be affected if the interest payments on the loan were received
semiannually?

With LIBOR at 4%: Year 1 Year 2


Interest received in year $40,000 Interest received in year $40,000
Interest received at year-end $40,000 Interest received at year-end $40,000
Reinvested interest $1,600 Reinvested interest $1,600
Interest paid in year 1 $75,000 Interest paid in year 2 $75,000
Net interest income in year 1 $ 6,600 Net interest income in year 2 $ 6,600

With LIBOR at 6%: Year 1 Year 2


Interest received in year $50,000 Interest received in year $50,000
Interest received at year-end $50,000 Interest received at year-end $50,000
Reinvested interest $2,500 Reinvested interest $2,500
Interest paid in year 1 $95,000 Interest paid in year 2 $95,000
Net interest income in year 1 $ 7,500 Net interest income in year 2 $ 7,500

With LIBOR at 2%: Year 1 Year 2


Interest received in year $30,000 Interest received in year: $30,000
Interest received at year-end $30,000 Interest received at year-end $30,000
Reinvested interest $900 Reinvested interest $900
Interest paid in year 1 $55,000 Interest paid in year 2 $55,000
Net interest income in year 1 $ 5,900 Net interest income in year 2 $ 5,900

e. What implications do these results have on the effectiveness of the maturity model as an
immunization strategy?

Even though the maturity gap is zero, the portfolio is not fully immunized. That is because the
timings of the cash flows are not the same for the assets and liabilities. The only way to immunize
using the maturity model is if the timing of the cash flows for both assets and liabilities are the
same, as demonstrated in Problem 12(c).

29. What are the weaknesses of the maturity model?

First, the maturity model does not consider the degree of leverage on the balance sheet. For example, if
assets are not financed entirely with deposits, a change in interest rates may cause the assets to change in
value by a different amount than the liabilities. Second, the maturity model does not take into account
the timing of the cash flows of either the assets or the liabilities, and thus reinvestment and/or refinancing
risk may become important factors in profitability and valuation as interest rates change.

The following questions and problems are based on material in the chapter appendix.
16
30. The current one-year Treasury bill rate is 5.2 percent, and the expected one-year rate 12 months
from now is 5.8 percent. According to the unbiased expectations theory, what should be the current
rate for a 2-year Treasury security?

(1.052)(1.058) = (1 + R2)2 = 1.113016; (1 + R2) = 1.054996 R2 = .0550 or 5.50 percent

31. A recent edition of The Wall Street Journal reported interest rates of 6 percent, 6.35 percent, 6.65
percent, and 6.75 percent for three-year, four-year, five-year, and six-year Treasury notes,
respectively. According to the unbiased expectations theory, what are the expected one-year rates
for years 4, 5, and 6?

[1 + E(ri)] = (1 + R i)i (1 + Ri-1)i-1


[1 + E(r4)] = (1.0635)4 (1.06)3 = 1.0741 r4 = 7.41 percent for period 4
[1 + E(r5)] = (1.0665)5 (1.0635)4 = 1.0786 r5 = 7.86 percent for period 5
[1 + E(r6)] = (1.0675)6 (1.0665)5 = 1.0725 r6 = 7.25 percent for period 6

32. How does the liquidity premium theory of the term structure of interest rates differ from the
unbiased expectations theory? In a normal economic environment, that is, an upward sloping yield
curve, what is the relationship of liquidity premiums for successive years into the future? Why?

The unbiased expectations theory asserts that long-term rates are a geometric average of current and
expected short-term rates. The liquidity premium theory asserts that long-term rates are a geometric
average of current and expected short-term rates plus a liquidity risk premium. The premium is assumed
to increase with the maturity of the security because the uncertainty of future returns grows as maturity
increases.

17
Chapter Nine
Interest Rate Risk II

Chapter Outline

Introduction

Duration

A General Formula for Duration


The Duration of Interest Bearing Bonds
The Duration of a Zero-Coupon Bond
The Duration of a Consol Bond (Perpetuities)

Features of Duration
Duration and Maturity
Duration and Yield
Duration and Coupon Interest

The Economic Meaning of Duration


Semiannual Coupon Bonds

Duration and Immunization


Duration and Immunizing Future Payments
Immunizing the Whole Balance Sheet of an FI

Immunization and Regulatory Considerations

Difficulties in Applying the Duration Model


Duration Matching can be Costly
Immunization is a Dynamic Problem
Large Interest Rate Changes and Convexity

Summary

Appendix 9A: Incorporating Convexity into the Duration Model


The Problem of the Flat Term Structure
The Problem of Default Risk
Floating-Rate Loans and Bonds
Demand Deposits and Passbook Savings
Mortgages and Mortgage-Backed Securities
Futures, Options, Swaps, Caps, and Other Contingent Claims

83
Solutions for End-of-Chapter Questions and Problems: Chapter Nine

1. What are the two different general interpretations of the concept of duration, and what is
the technical definition of this term? How does duration differ from maturity?

Duration measures the average life of an asset or liability in economic terms. As such, duration
has economic meaning as the interest sensitivity (or interest elasticity) of an assets value to
changes in the interest rate. Duration differs from maturity as a measure of interest rate
sensitivity because duration takes into account the time of arrival and the rate of reinvestment of
all cash flows during the assets life. Technically, duration is the weighted-average time to
maturity using the relative present values of the cash flows as the weights.

2. Two bonds are available for purchase in the financial markets. The first bond is a 2-year,
$1,000 bond that pays an annual coupon of 10 percent. The second bond is a 2-year,
$1,000, zero-coupon bond.

a. What is the duration of the coupon bond if the current yield-to-maturity (YTM) is 8
percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet
program to assist in the calculations.)

Coupon Bond
Par value = $1,000 Coupon = 0.10 Annual payments
YTM = 0.08 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $100.00 0.92593 $92.59 $92.59
2 $1,100.00 0.85734 $943.07 $1,886.15
Price = $1,035.67
Numerator = $1,978.74 Duration = 1.9106 = Numerator/Price

YTM = 0.10
Time Cash Flow PVIF PV of CF PV*CF*T
1 $100.00 0.90909 $90.91 $90.91
2 $1,100.00 0.82645 $909.09 $1,818.18
Price = $1,000.00
Numerator = $1,909.09 Duration = 1.9091 = Numerator/Price

YTM = 0.12
Time Cash Flow PVIF PV of CF PV*CF*T
1 $100.00 0.89286 $89.29 $89.29
2 $1,100.00 0.79719 $876.91 $1,753.83
Price = $966.20
Numerator = $1,843.11 Duration = 1.9076 = Numerator/Price

84
b. How does the change in the current YTM affect the duration of this coupon bond?

Increasing the yield-to-maturity decreases the duration of the bond.

c. Calculate the duration of the zero-coupon bond with a YTM of 8 percent, 10 percent,
and 12 percent.

Zero Coupon Bond


Par value = $1,000 Coupon = 0.00
YTM = 0.08 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $0.00 0.92593 $0.00 $0.00
2 $1,000.00 0.85734 $857.34 $1,714.68
Price = $857.34
Numerator = $1,714.68 Duration = 2.0000 = Numerator/Price

YTM = 0.10
Time Cash Flow PVIF PV of CF PV*CF*T
1 $0.00 0.90909 $0.00 $0.00
2 $1,000.00 0.82645 $826.45 $1,652.89
Price = $826.45
Numerator = $1,652.89 Duration = 2.0000 = Numerator/Price

YTM = 0.12
Time Cash Flow PVIF PV of CF PV*CF*T
1 $0.00 0.89286 $0.00 $0.00
2 $1,000.00 0.79719 $797.19 $1,594.39
Price = $797.19
Numerator = $1,594.39 Duration = 2.0000 = Numerator/Price

d. How does the change in the current YTM affect the duration of the zero-coupon bond?

Changing the yield-to-maturity does not affect the duration of the zero coupon bond.

e. Why does the change in the YTM affect the coupon bond differently than the zero-
coupon bond?

Increasing the YTM on the coupon bond allows for a higher reinvestment income that more
quickly recovers the initial investment. The zero-coupon bond has no cash flow until
maturity.

85
3. A one-year, $100,000 loan carries a market interest rate of 12 percent. 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 is the duration of this loan?

Cash flow in 6 months = $100,000 x .12 x .5 + $50,000 = $56,000 interest and principal.
Cash flow in 1 year = $50,000 x 1.06 = $53,000 interest and principal.

Time Cash Flow PVIF CF*PVIF T*CF*CVIF


1 $56,000 0.943396 $52,830.19 $52,830.19
2 $53,000 0.889996 $47,169.81 $94,339.62
Price = $100,000.00 $147,169.81 = Numerator

$147 ,169 .81 1


D x 0.735849 years
$100 ,000 .00 2

b. What will be the cash flows at the end of 6 months and at the end of the year?

Cash flow in 6 months = $100,000 x .12 x .5 + $50,000 = $56,000 interest and principal.
Cash flow in 1 year = $50,000 x 1.06 = $53,000 interest and principal.

c. What is the present value of each cash flow discounted at the market rate? What is the
total present value?

$56,000 1.06 = $52,830.19 = PVCF1


$53,000 (1.06)2 = $47,169.81 = PVCF2
=$100,000.00 = PV Total CF

d. What proportion of the total present value of cash flows occurs at the end of 6 months?
What proportion occurs at the end of the year?

Proportiont=.5 = $52,830.19 $100,000 x 100 = 52.830 percent.


Proportiont=1 = $47,169.81 $100,000 x 100 = 47.169 percent.

e. What is the weighted-average life of the cash flows on the loan?

D = 0.5283 x 0.5 years + 0.47169 x 1.0 years = 0.26415 + 0.47169 = 0.73584 years.

f. How does this weighted-average life compare to the duration calculated in part (a)
above?

The two values are the same.

86
4. What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual
coupon selling at par? Selling with a YTM of 12 percent? 14 percent? What can you
conclude about the relationship between duration and yield to maturity? Plot the
relationship. Why does this relationship exist?

Five-year Treasury Bond


Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.10 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.95238 $47.62 $23.81 PVIF = 1/(1+YTM/2)^(Time*2)
1 $50.00 0.90703 $45.35 $45.35
1.5 $50.00 0.86384 $43.19 $64.79
2 $50.00 0.8227 $41.14 $82.27
2.5 $50.00 0.78353 $39.18 $97.94
3 $50.00 0.74622 $37.31 $111.93
3.5 $50.00 0.71068 $35.53 $124.37
4 $50.00 0.67684 $33.84 $135.37
4.5 $50.00 0.64461 $32.23 $145.04
5 $1,050.00 0.61391 $644.61 $3,223.04
Price = $1,000.00
Numerator = $4,053.91 Duration = 4.0539 = Numerator/Price

Five-year Treasury Bond


Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.12 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.9434 $47.17 $23.58 Duration YTM
1 $50.00 0.89 $44.50 $44.50 4.0539 0.10
1.5 $50.00 0.83962 $41.98 $62.97 4.0113 0.12
2 $50.00 0.79209 $39.60 $79.21 3.9676 0.14
2.5 $50.00 0.74726 $37.36 $93.41
3 $50.00 0.70496 $35.25 $105.74
3.5 $50.00 0.66506 $33.25 $116.38
4 $50.00 0.62741 $31.37 $125.48
4.5 $50.00 0.5919 $29.59 $133.18
5 $1,050.00 0.55839 $586.31 $2,931.57 .
Price = $926.40
Numerator = $3,716.03 Duration = 4.0113 = Numerator/Price

87
Five-year Treasury Bond
Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.14 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.93458 $46.73 $23.36
1 $50.00 0.87344 $43.67 $43.67
1.5 $50.00 0.8163 $40.81 $61.22
2 $50.00 0.7629 $38.14 $76.29
2.5 $50.00 0.71299 $35.65 $89.12
3 $50.00 0.66634 $33.32 $99.95
3.5 $50.00 0.62275 $31.14 $108.98
4 $50.00 0.58201 $29.10 $116.40
4.5 $50.00 0.54393 $27.20 $122.39
5 $1,050.00 0.50835 $533.77 $2,668.83
Price = $859.53
Numerator = $3,410.22 Duration = 3.9676 = Numerator/Price

Duration and YTM As the yield to maturity increases, duration decreases


because of the reinvestment of interim cash flows at
4.08 higher rates.
4.0539
4.04
4.0113
Y ears

4.00
3.9676
3.96

3.92
0.10 0.12 0.14
Yield to Maturity

5. Consider three Treasury bonds each of which has a 10 percent semiannual coupon and
trades at par.

a. Calculate the duration for a bond that has a maturity of 4 years, 3 years, and 2 years?

Please see the calculations on the next page.

88
a. Four-year Treasury Bond
Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.10 Maturity = 4
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.952381 $47.62 $23.81 PVIF = 1/(1+YTM/2)^(Time*2)
1 $50.00 0.907029 $45.35 $45.35
1.5 $50.00 0.863838 $43.19 $64.79
2 $50.00 0.822702 $41.14 $82.27
2.5 $50.00 0.783526 $39.18 $97.94
3 $50.00 0.746215 $37.31 $111.93
3.5 $50.00 0.710681 $35.53 $124.37
4 $1,050.00 0.676839 $710.68 $2,842.73
Price = $1,000.00
Numerator = $3,393.19 Duration = 3.3932 = Numerator/Price

Three-year Treasury Bond


Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.10 Maturity = 3
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.952381 $47.62 $23.81 PVIF = 1/(1+YTM/2)^(Time*2)
1 $50.00 0.907029 $45.35 $45.35
1.5 $50.00 0.863838 $43.19 $64.79
2 $50.00 0.822702 $41.14 $82.27
2.5 $50.00 0.783526 $39.18 $97.94
3 $1,050.00 0.746215 $783.53 $2,350.58
Price = $1,000.00
Numerator = $2,664.74 Duration = 2.6647 = Numerator/Price

Two-year Treasury Bond


Par value = $1,000 Coupon = 0.10 Semiannual payments
YTM = 0.10 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $50.00 0.952381 $47.62 $23.81 PVIF = 1/(1+YTM/2)^(Time*2)
1 $50.00 0.907029 $45.35 $45.35
1.5 $50.00 0.863838 $43.19 $64.79
2 $1,050.00 0.822702 $863.84 $1,727.68
Price = $1,000.00
Numerator = $1,861.62 Duration = 1.8616 = Numerator/Price

b. What conclusions can you reach about the relationship of duration and the time to
maturity? Plot the relationship.

89
As maturity decreases, duration decreases at a decreasing rate. Although the graph below
does not illustrate with great precision, the change in duration is less than the change in
time to maturity.

Duration and Maturity


Change in
Duration Maturity Duration
4.00
1.8616 2 3.3932
2.6647 3 0.8031 3.00
3.3932 4 0.7285

Year s
2.6647
2.00
1.8616
1.00

0.00
2 3 4
Tim e to Maturity

6. A six-year, $10,000 CD pays 6 percent interest annually. What is the duration of the CD?
What would be the duration if interest were paid semiannually? What is the relationship of
duration to the relative frequency of interest payments?

Six-year CD
Par value = $10,000 Coupon = 0.06 Annual payments
YTM = 0.06 Maturity = 6
Time Cash Flow PVIF PV of CF PV*CF*T
1 $600.00 0.94340 $566.04 $566.04 PVIF = 1/(1+YTM)^(Time)
2 $600.00 0.89000 $534.00 $1,068.00
3 $600.00 0.83962 $503.77 $1,511.31
4 $600.00 0.79209 $475.26 $1,901.02
5 $600.00 0.74726 $448.35 $2,241.77
6 $10,600 0.70496 $7,472.58 $44,835.49
Price = $10,000.00
Numerator = $52,123.64 Duration = 5.2124 = Numerator/Price

Six-year CD
Par value = $10,000 Coupon = 0.06 Semiannual payments
YTM = 0.06 Maturity = 6
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $300.00 0.970874 $291.26 $145.63 PVIF = 1/(1+YTM/2)^(Time*2)
1 $300.00 0.942596 $282.78 $282.78
1.5 $300.00 0.915142 $274.54 $411.81

90
2 $300.00 0.888487 $266.55 $533.09
2.5 $300.00 0.862609 $258.78 $646.96
3 $300.00 0.837484 $251.25 $753.74
3.5 $300.00 0.813092 $243.93 $853.75
4 $300.00 0.789409 $236.82 $947.29
4.5 $300.00 0.766417 $229.93 $1,034.66
5 $300.00 0.744094 $223.23 $1,116.14
5.5 $300.00 0.722421 $216.73 $1,192.00
6 $10,300 0.701380 $7,224.21 $43,345.28
Price = $10,000.00
Numerator = $51,263.12 Duration = 5.1263 = Numerator/Price

Duration decreases as the frequency of payments increases. This relationship occurs because (a)
cash is being received more quickly, and (b) reinvestment income will occur more quickly from
the earlier cash flows.

7. What is the duration of a consol bond that sells at a YTM of 8 percent? 10 percent? 12
percent? What is a consol bond? Would a consol trading at a YTM of 10 percent have a
greater duration than a 20-year zero-coupon bond trading at the same YTM? Why?

A consol is a bond that pays a fixed coupon each year forever. A consol Consol Bond
trading at a YTM of 10 percent has a duration of 11 years, while a zero- YTM D = 1 + 1/R
coupon bond trading at a YTM of 10 percent, or any other YTM, has a 0.08 13.50 years
duration of 20 years because no cash flows occur before the twentieth 0.10 11.00 years
year. 0.12 9.33 years

8. Maximum Pension Fund is attempting to balance one of the bond portfolios under its
management. The fund has identified three bonds which have five-year maturities and
which trade at a YTM of 9 percent. The bonds differ only in that the coupons are 7
percent, 9 percent, and 11 percent.

a. What is the duration for each bond?

Five-year Bond
Par value = $1,000 Coupon = 0.07 Annual payments
YTM = 0.09 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $70.00 0.917431 $64.22 $64.22 PVIF = 1/(1+YTM)^(Time)
2 $70.00 0.841680 $58.92 $117.84
3 $70.00 0.772183 $54.05 $162.16
4 $70.00 0.708425 $49.59 $198.36
5 $1,070.00 0.649931 $695.43 $3,477.13
Price = $922.21
Numerator = $4,019.71 Duration = 4.3588 = Numerator/Price

91
Five-year Bond
Par value = $1,000 Coupon = 0.09 Annual payments
YTM = 0.09 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $90.00 0.917431 $82.57 $82.57 PVIF = 1/(1+YTM)^(Time)
2 $90.00 0.841680 $75.75 $151.50
3 $90.00 0.772183 $69.50 $208.49
4 $90.00 0.708425 $63.76 $255.03
5 $1,090.00 0.649931 $708.43 $3,542.13
Price = $1,000.00
Numerator = $4,239.72 Duration = 4.2397 = Numerator/Price

Five-year Bond
Par value = $1,000 Coupon = 0.11 Annual payments
YTM = 0.09 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $110.00 0.917431 $100.92 $100.92 PVIF = 1/(1+YTM)^(Time)
2 $110.00 0.841680 $92.58 $185.17
3 $110.00 0.772183 $84.94 $254.82
4 $110.00 0.708425 $77.93 $311.71
5 $1,110.00 0.649931 $721.42 $3,607.12
Price = $1,077.79
Numerator = $4,459.73 Duration = 4.1378 = Numerator/Price

b. What is the relationship between duration and the amount of coupon interest that is
paid? Plot the relationship.

Duration and Coupon Rates Duration decreases as the amount of coupon


interest increases.
Change in
4.3588 Duration Coupon Duration
4.3588 7%
Years

4.2397
4.1378 4.2397 9% -0.1191
4.1378 11% -0.1019
4.00
7% 9% 11%
C oupon Rates

92
9. An insurance company is analyzing three bonds and is using duration as the measure of
interest rate risk. All three bonds trade at a YTM of 10 percent and have $10,000 par
values. The bonds differ only in the amount of annual coupon interest that they pay: 8, 10,
or 12 percent.

a. What is the duration for each five-year bond?

Five-year Bond
Par value = $10,000 Coupon = 0.08 Annual payments
YTM = 0.10 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $800.00 0.909091 $727.27 $727.27 PVIF = 1/(1+YTM)^(Time)
2 $800.00 0.826446 $661.16 $1,322.31
3 $800.00 0.751315 $601.05 $1,803.16
4 $800.00 0.683013 $546.41 $2,185.64
5 $10,800.00 0.620921 $6,705.95 $33,529.75
Price = $9,241.84
Numerator = $39,568.14 Duration = 4.2814 = Numerator/Price

Five-year Bond
Par value = $10,000 Coupon = 0.10 Annual payments
YTM = 0.10 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $1,000.00 0.909091 $909.09 $909.09 PVIF = 1/(1+YTM)^(Time)
2 $1,000.00 0.826446 $826.45 $1,652.89
3 $1,000.00 0.751315 $751.31 $2,253.94
4 $1,000.00 0.683013 $683.01 $2,732.05
5 $11,000.00 0.620921 $6,830.13 $34,150.67
Price = $10,000.00
Numerator = $41,698.65 Duration = 4.1699 = Numerator/Price

Five-year Bond
Par value = $10,000 Coupon = 0.12 Annual payments
YTM = 0.10 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $1,200.00 0.909091 $1,090.91 $1,090.91 PVIF = 1/(1+YTM)^(Time)
2 $1,200.00 0.826446 $991.74 $1,983.47
3 $1,200.00 0.751315 $901.58 $2,704.73
4 $1,200.00 0.683013 $819.62 $3,278.46
5 $11,200.00 0.620921 $6,954.32 $34,771.59
Price = $10,758.16
Numerator = $43,829.17 Duration = 4.0740 = Numerator/Price

93
b. What is the relationship between duration and the amount of coupon interest that is paid?

Duration and Coupon Rates


Duration decreases as the amount of coupon
4.50
interest increases.
Change in
4.2814 Duration Coupon Duration
Years

4.1699 4.2814 7%
4.0740 4.1699 9% -0.1115
4.00 4.0740 11% -0.0959
8% 10% 12%
Coupon Rates

10. You can obtain a loan for $100,000 at a rate of 10 percent for two years. You have a choice
of either paying the principal at the end of the second year or amortizing the loan, that is,
paying interest and principal in equal payments each year. The loan is priced at par.

a. What is the duration of the loan under both methods of payment?


Two-year loan: Principal and interest at end of year two.
Par value = 100,000 Coupon = 0.00 No annual payments
YTM = 0.10 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $0.00 0.90909 $0.00 $0.00 PVIF = 1/(1+YTM)^(Time)
2 $121,000 0.82645 $100,000.0 200,000.00
Price = $100,000.0
Numerator = 200,000.00 Duration = 2.0000 = Numerator/Price
Two-year loan: Interest at end of year one, P & I at end of year two.
Par value = 100,000 Coupon = 0.10 Annual payments
YTM = 0.10 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $10,000 0.909091 $9,090.91 $9,090.91 PVIF = 1/(1+YTM)^(Time)
2 $110,000 0.826446 $90,909.09 181,818.18
Price = $100,000.0
Numerator = 190,909.09 Duration = 1.9091 = Numerator/Price

Two-year loan: Amortized over two years. Amortized payment of $57.619.05


Par value = 100,000 Coupon = 0.10
YTM = 0.10 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $57,619.05 0.909091 $52,380.95 $52,380.95 PVIF = 1/(1+YTM)^(Time)
2 $57,619.05 0.826446 $47,619.05 $95,238.10
Price = $100,000.0
Numerator = 147,619.05 Duration = 1.4762 = Numerator/Price

94
b. Explain the difference in the two results?
Duration decreases dramatically when a
portion of the principal is repaid at the end of Duration and Repayment Choice
year one. Duration often is described as the
weighted-average maturity of an asset. If 2.25
2.0000 1.9091
more weight is given to early payments, the

Years
effective maturity of the asset is reduced. 1.75
1.4762
Repayment Change in 1.25
Duration Provisions Duration 1 2 3
2.0000 P&I@2 Repayment Alternatives
1.9091 I@1,P&I@2 -0.0909
1.4762 Amortize -0.4329

11. How is duration related to the interest elasticity of a fixed-income security? What is the
relationship between duration and the price of the fixed-income security?

Taking the first derivative of a bonds (or any fixed-income security) price (P) with respect to the
yield to maturity (R) provides the following:
dP
P D
dR
(1 R )
The economic interpretation is that D is a measure of the percentage change in price of a bond
for a given percentage change in yield to maturity (interest elasticity). This equation can be
rewritten to provide a practical application:
dR
dP D P
1 R

In other words, if duration is known, then the change in the price of a bond due to small changes
in interest rates, R, can be estimated using the above formula.

12. You have discovered that the price of a bond rose from $975 to $995 when the YTM fell
from 9.75 percent to 9.25 percent. What is the duration of the bond?

P 20
We know D P 975 4.5 years D 4.5 years
R .005
(1 R) 1.0975

13. Calculate the duration of a 2-year, $1,000 bond that pays an annual coupon of 10 percent
and trades at a yield of 14 percent. What is the expected change in the price of the bond if
interest rates decline by 0.50 percent (50 basis points)?

95
Two-year Bond
Par value = $1,000 Coupon = 0.10 Annual payments
YTM = 0.14 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $100.00 0.87719 $87.72 $87.72 PVIF = 1/(1+YTM)^(Time)
2 $1,100.00 0.76947 $846.41 $1,692.83
Price = $934.13
Numerator = $1,780.55 Duration = 1.9061 = Numerator/Price

R .005
Expected change in price = D P 1.9061 $934.13 $7.81 . This implies a new
1 R 1.14
price of $941.94. The actual price using conventional bond price discounting would be $941.99.
The difference of $0.05 is due to convexity, which was not considered in this solution.

14. The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semiannual coupon
and selling at par has been estimated at 6.9 years.

a. What is the modified duration of the bond (Modified Duration = D/(1 + R))?

MD = 6.9/(1 + .10/2) = 6.57 years

b. What will be the estimated price change of the bond if market interest rates increase
0.10 percent (10 basis points)? If rates decrease 0.20 percent (20 basis points)?

Estimated change in price = -MD x R x P = -6.57 x 0.001 x $1,000 = -$6.57.

Estimated change in price = -MD x R x P = -6.57 x -0.002 x $1,000 = $13.14.

c. What would be the actual price of the bond under each rate change situation in part (b)
using the traditional present value bond pricing techniques? What is the amount of
error in each case?

Rate Price Actual


Change Estimated Price Error
+ 0.001 $993.43 $993.45 $0.02
- 0.002 $1,013.14 $1,013.28 -$0.14

15. Suppose you purchase a five-year, 13.76 percent bond that is priced to yield 10 percent.

a. Show that the duration of this annual payment bond is equal to four years.

Five-year Bond
Par value = $1,000 Coupon = 0.1376 Annual payments
YTM = 0.10 Maturity = 5

96
Time Cash Flow PVIF PV of CF PV*CF*T
1 $137.60 0.909091 $125.09 $125.09 PVIF = 1/(1+YTM)^(Time)
2 $137.60 0.826446 $113.72 $227.44
3 $137.60 0.751315 $103.38 $310.14
4 $137.60 0.683013 $93.98 $375.93
5 $1,137.60 0.620921 $706.36 $3,531.80
Price = $1,142.53
Numerator = $4,570.40 Duration = 4.0002 = Numerator/Price

b. Show that, if interest rates rise to 11 percent within the next year and that if your
investment horizon is four years from today, you will still earn a 10 percent yield on
your investment.

Value of bond at end of year four: PV = ($137.60 + $1,000) 1.11 = $1,024.86.


Future value of interest payments at end of year four: $137.60*FVIFn=4, i=11% = $648.06.
Future value of all cash flows at n = 4:
Coupon interest payments over four years $550.40
Interest on interest at 11 percent 97.66
Value of bond at end of year four $1,024.86
Total future value of investment $1,672.92

Yield on purchase of asset at $1,142.53 = $1,672.92*PVIVn=4, i=?% i = 10.002332%.

c. Show that a 10 percent yield also will be earned if interest rates fall next year to 9
percent.

Value of bond at end of year four: PV = ($137.60 + $1,000) 1.09 = $1,043.67.


Future value of interest payments at end of year four: $137.60*FVIFn=4, i=9% = $629.26.
Future value of all cash flows at n = 4:
Coupon interest payments over four years $550.40
Interest on interest at 9 percent 78.86
Value of bond at end of year four $1,043.67
Total future value of investment $1,672.93

Yield on purchase of asset at $1,142.53 = $1,672.93*PVIVn=4, i=?% i = 10.0025 percent.

16. Consider the case where an investor holds a bond for a period of time longer than the
duration of the bond, that is, longer than the original investment horizon.

a. If market interest rates rise, will the return that is earned exceed or fall short of the
original required rate of return? Explain.

In this case the actual return earned would exceed the yield expected at the time of
purchase. The benefits from a higher reinvestment rate would exceed the price reduction
effect if the investor holds the bond for a sufficient length of time.

97
b. What will happen to the realized return if market interest rates decrease? Explain.

If market rates decrease, the realized yield on the bond will be less than the expected yield
because the decrease in reinvestment earnings will be greater than the gain in bond value.

c. Recalculate parts (b) and (c) of problem 15 above, assuming that the bond is held for all
five years, to verify your answers to parts (a) and (b) of this problem.

The case where interest rates rise to 11 percent, n = five years:


Future value of interest payments at end of year five: $137.60*FVIFn=5, i=11% = $856.95.
Future value of all cash flows at n = 5:
Coupon interest payments over five years $688.00
Interest on interest at 11 percent 168.95
Value of bond at end of year five $1,000.00
Total future value of investment $1,856.95
Yield on purchase of asset at $1,142.53 = $1,856.95*PVIFn=5, i=?% i = 10.2012 percent.

The case where interest rates fall to 9 percent, n = five years:


Future value of interest payments at end of year five: $137.60*FVIFn=5, i=9% = $823.50.
Future value of all cash flows at n = 5:
Coupon interest payments over five years $688.00
Interest on interest at 9 percent 135.50
Value of bond at end of year five $1,000.00
Total future value of investment $1,823.50

Yield on purchase of asset at $1,142.53 = $1,823.50*PVIVn=5, i=?% i = 9.8013 percent.

d. If either calculation in part (c) is greater than the original required rate of return, why
would an investor ever try to match the duration of an asset with his investment
horizon?

The answer has to do with the ability to forecast interest rates. Forecasting interest rates is
a very difficult task, one that most financial institution money managers are unwilling to
do. For most managers, betting that rates would rise to 11 percent to provide a realized
yield of 10.20 percent over five years is not a sufficient return to offset the possibility that
rates could fall to 9 percent and thus give a yield of only 9.8 percent over five years.

17. Two banks are being examined by the regulators to determine the interest rate sensitivity of
their balance sheets. Bank A has assets composed solely of a 10-year, 12 percent, $1
million loan. The loan is financed with a 10-year, 10 percent, $1 million CD. Bank B has
assets composed solely of a 7-year, 12 percent zero-coupon bond with a current (market)
value of $894,006.20 and a maturity (principal) value of $1,976,362.88. The bond is
financed with a 10-year, 8.275 percent coupon, $1,000,000 face value CD with a YTM of
10 percent. The loan and the CDs pay interest annually, with principal due at maturity.

98
a. If market interest rates increase 1 percent (100 basis points), how do the market values
of the assets and liabilities of each bank change? That is, what will be the net affect on
the market value of the equity for each bank?

For Bank A, an increase of 100 basis points in interest rate will cause the market values of
assets and liabilities to decrease as follows:
Loan: $120*PVIVAn=10,i=13% + $1,000*PVIV n=10,i=13% = $945,737.57.
CD: $100*PVIVAn=10,i=11% + $1,000*PVIV n=10,i=11% = $941,107.68.
Therefore, the decrease in value of the asset was $4,629.89 less than the liability.

For Bank B:
Bond: $1,976,362.88*PVIVn=7,i=13% = $840,074.08.
CD: $82.75*PVIVA n=10,i=11% + $1,000*PVIVn=10,i=11% = $839,518.43.
The bond value decreased $53,932.12, and the CD value fell $54,487.79. Therefore,
the decrease in value of the asset was $555.67 less than the liability.

b. What accounts for the differences in the changes of the market value of equity between
the two banks?

The assets and liabilities of Bank A change in value by different amounts because the
durations of the assets and liabilities are not the same, even though the face values and
maturities are the same. For Bank B, the maturities of the assets and liabilities are
different, but the current market values and durations are the same. Thus the change in
interest rates causes the same (approximate) change in value for both liabilities and assets.

c. Verify your results above by calculating the duration for the assets and liabilities of
each bank, and estimate the changes in value for the expected change in interest rates.
Summarize your results.

Ten-year CD:Bank B (Calculation in millions)


Par value = $1,000 Coupon = 0.08 Annual payments
YTM = 0.10 Maturity = 10
Time Cash Flow PVIF PV of CF PV*CF*T
1 $82.75 0.909091 $75.23 $75.23 PVIF = 1/(1+YTM)^(Time)
2 $82.75 0.826446 $68.39 $136.78
3 $82.75 0.751315 $62.17 $186.51
4 $82.75 0.683013 $56.52 $226.08
5 $82.75 0.620921 $51.38 $256.91
6 $82.75 0.564474 $46.71 $280.26
7 $82.75 0.513158 $42.46 $297.25
8 $82.75 0.466507 $38.60 $308.83
9 $82.75 0.424098 $35.09 $315.85
10 $1,082.75 0.385543 $417.45 $4,174.47
Price = $894.006
Numerator = $6,258.15 Duration = 7.0001 = Numerator/Price

99
The duration for the CD of Bank B is calculated above to be 7.001 years. Since the bond is
a zero-coupon, the duration is equal to the maturity of 7 years.

Using the duration formula to estimate the change in value:


R .01
Bond: Value = D P 7.0 $894,006 .20 $55,875.39
1 R 1.12

R .01
CD: Value = D P 7.0001 $894 ,006.22 $56,899.43
1 R 1.10

The difference in the change in value of the assets and liabilities for Bank B is $1,024.04
using the duration estimation model. The small difference in this estimate and the estimate
found in part a above is due to the convexity of the two financial assets.

The duration estimates for the loan and CD for Bank A are presented below:

Ten-year Loan: Bank A (Calculation in millions)


Par value = $1,000 Coupon = 0.12 Annual payments
YTM = 0.12 Maturity = 10
Time Cash Flow PVIF PV of CF PV*CF*T
1 $120.00 0.892857 $107.14 $107.14 PVIF = 1/(1+YTM)^(Time)
2 $120.00 0.797194 $95.66 $191.33
3 $120.00 0.711780 $85.41 $256.24
4 $120.00 0.635518 $76.26 $305.05
5 $120.00 0.567427 $68.09 $340.46
6 $120.00 0.506631 $60.80 $364.77
7 $120.00 0.452349 $54.28 $379.97
8 $120.00 0.403883 $48.47 $387.73
9 $120.00 0.360610 $43.27 $389.46
10 $1,120.00 0.321973 $360.61 $3,606.10
Price = $1,000.00
Numerator = $6,328.25 Duration = 6.3282 = Numerator/Price

Ten-year CD: Bank A (Calculation in millions)


Par value = $1,000 Coupon = 0.10 Annual payments
YTM = 0.10 Maturity = 10
Time Cash Flow PVIF PV of CF PV*CF*T
1 $100.00 0.909091 $90.91 $90.91 PVIF = 1/(1+YTM)^(Time)
2 $100.00 0.826446 $82.64 $165.29
3 $100.00 0.751315 $75.13 $225.39
4 $100.00 0.683013 $68.30 $273.21
5 $100.00 0.620921 $62.09 $310.46

100
6 $100.00 0.564474 $56.45 $338.68
7 $100.00 0.513158 $51.32 $359.21
8 $100.00 0.466507 $46.65 $373.21
9 $100.00 0.424098 $42.41 $381.69
10 $1,100.00 0.385543 $424.10 $4,240.98
Price = $1,000.00
Numerator = $6,759.02 Duration = 6.7590 = Numerator/Price

Using the duration formula to estimate the change in value:


R .01
Loan: Value = D P 6.3282 $1,000,000 $56,501.79
1 R 1.12

R .01
CD: Value = D P 6.7590 $1,000,000 $61,445 .45
1 R 1.10

The difference in the change in value of the assets and liabilities for Bank A is $4,943.66
using the duration estimation model. The small difference in this estimate and the estimate
found in part a above is due to the convexity of the two financial assets. The reason the
change in asset values for Bank A is considerably larger than for Bank B is because of the
difference in the durations of the loan and CD for Bank A.

18. If you use only duration to immunize your portfolio, what three factors affect changes in
the net worth of a financial institution when interest rates change?

The change in net worth for a given change in interest rates is given by the following equation:
R
E D A DL k
L
* A* where k
1 R A

Thus, three factors are important in determining E.

1) [D A - D L k] or the leveraged adjusted duration gap. The larger this gap, the more
exposed is the FI to changes in interest rates.
2) A, or the size of the FI. The larger is A, the larger is the exposure to interest rate
changes.
3) R/1 + R, or interest rate shocks. The larger is the shock, the larger is the exposure.

19. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent


semiannual coupon Treasury bond selling at par. The duration of this bond has been
estimated at 9.94 years. The assets are financed with equity and a $900,000, 2-year, 7.25
percent semiannual coupon capital note selling at par.

a. What is the leverage-adjusted duration gap of Financial Institution XY?

The duration of the capital note is 1.8975 years.

101
Two-year Capital Note
Par value = $900 Coupon = 0.0725 Semiannual payments
YTM = 0.0725 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $32.63 0.965018 $31.48 $15.74 PVIF = 1/(1+YTM/2)^(Time*2)
1 $32.63 0.931260 $30.38 $30.38
1.5 $32.63 0.898683 $29.32 $43.98
2 $932.63 0.867245 $808.81 $1,617.63
Price = $900.00
Numerator = $1,707.73 Duration = 1.8975 = Numerator/Price

The leverage-adjusted duration gap can be found as follows:


Leverage adjusted duration gap
D A D L k
$900 ,000
9.94 1.8975 8.23 years
$1,000 ,000

b. What is the impact on equity value if the relative change in all market interest rates is a
decrease of 20 basis points? Note, the relative change in interest rates is R/(1+R/2) =
-0.0020.

The change in net worth using leverage adjusted duration gap is given by:

E
D A D L k
* A*
R
R

9.94 (1.8975) 9
10

(.002)(1,000,000) $16, 464
1
2
c. Using the information that you calculated in parts (a) and (b), infer a general statement
about the desired duration gap for a financial institution if interest rates are expected to
increase or decrease.

If the FI wishes to be immune from the effects of interest rate risk, that is, either positive or
negative changes in interest rates, a desirable leverage-adjusted duration gap (LADG) is
zero. If the FI is confident that interest rates will fall, a positive LADG will provide the
greatest benefit. If the FI is confident that rates will increase, then negative LADG would
be beneficial.

d. Verify your inference by calculating the change in market value of equity assuming that
the relative change in all market interest rates is an increase of 30 basis points.
R
E D A D L k
* A* 8.23225 (1,000 ,000)(.003) $24,697
R
1
2
e. What would the duration of the assets need to be to immunize the equity from changes
in market interest rates?

Immunizing the equity from changes in interest rates requires that the LADG be 0. Thus,
(DA -DLk) = 0 D A = DLk, or DA = 0.9*1.8975 = 1.70775 years.

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20. The balance sheet for Gotbucks Bank, Inc. (GBI) is presented below ($ millions):

Assets Liabilities and Equity


Cash $30 Core deposits $20
Federal funds 20 Federal funds 50
Loans (floating) 105 Euro CDs 130
Loans (fixed) 65 Equity 20
Total assets $220 Total liabilities & equity $220

NOTES TO THE BALANCE SHEET: The Fed funds rate is 8.5 percent, the floating loan rate is
LIBOR + 4 percent, and currently LIBOR is 11 percent. Fixed rate loans have five-year
maturities, are priced at par, and pay 12 percent annual interest. Core deposits are fixed-rate for
2 years at 8 percent paid annually. Euros currently yield 9 percent.

a. What is the duration of the fixed-rate loan portfolio of Gotbucks Bank?

Five-year Loan
Par value = $1,000 Coupon = 0.1200 Annual payments
YTM = 0.12 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
1 $120.00 0.892857 $107.14 $107.14 PVIF = 1/(1+YTM)^(Time)
2 $120.00 0.797194 $95.66 $191.33
3 $120.00 0.711780 $85.41 $256.24
4 $120.00 0.635518 $76.26 $305.05
5 $1,120.00 0.567427 $635.52 $3,177.59
Price = $1,000.00
Numerator = $4,037.35 Duration = 4.0373 = Numerator/Price

The duration is 4.037 years.

b. If the duration of the floating-rate loans and fed funds is 0.36 years, what is the duration
of GBIs assets?

DA = [30(0) + 65(4.037) + 125(.36)]/220 = 1.397 years

c. What is the duration of the core deposits if they are priced at par?

Two-year Core
Deposits
Par value = $1,000 Coupon = 0.08 Annual payments
YTM = 0.08 Maturity = 2
Time Cash Flow PVIF PV of CF PV*CF*T
1 $80.00 0.92593 $74.07 $74.07 PVIF = 1/(1+YTM)^(Time)

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2 $1,080.00 0.85734 $925.93 $1,851.85
Price = $1,000.00
Numerator = $1,925.93 Duration = 1.9259 = Numerator/Price

The duration of the core deposits is 1.926 years.

d. If the duration of the Euro CDs and Fed funds liabilities is 0.401 years, what is the
duration of GBIs liabilities?

DL = [20*(1.926) + 180*(.401)]/200 = .5535 years

e. What is GBIs duration gap? What is its interest rate risk exposure?

GBIs leveraged adjusted duration gap is: 1.397 - 200/220 * (.5535) = .8938 years

f. What is the impact on the market value of equity if the relative change in all market
interest rates is an increase of 1 percent (100 basis points)? Note, the relative change in
interest rates is (R/(1+R)) = 0.01.

Since GBIs duration gap is positive, an increase in interest rates will lead to a decline in
net worth. For a 1 percent increase, the change in net worth is:

E = -0.8938 * (0.01) * $220 = -$1,966,360 (new net worth will be $18,033,640).

g. What is the impact on the market value of equity if the relative change in all market
interest rates is a decrease of 0.5 percent (-50 basis points)?

Since GBIs duration gap is positive, an decrease in interest rates will lead to an increase in
net worth. For a 0.5 percent decrease, the change in net worth is:

E = -0.8938 * (-0.005) * $220 = $983,180 (new net worth will be $20,983,180).

f. What variables are available to GBI to immunize the bank? How much would each
variable need to change to get DGAP equal to 0?

Immunization requires the bank to have a leverage-adjusted duration gap of 0.0. Therefore,
GBI could reduce the duration of its assets to 0.5535 years by using more fed funds and
floating rate loans. Or GBI could use a combination of reducing asset duration and
increasing liability duration in such a manner that LADG is 0.0.

21. Hands Insurance Company issued a $90 million, 1-year, zero-coupon note at 8 percent add-
on annual interest (paying one coupon at the end of the year). The proceeds were used to
fund a $100 million, 2-year commercial loan at 10 percent annual interest. Immediately
after these transactions were simultaneously closed, all market interest rates increased 1.5
percent (150 basis points).

104
a. What is the true market value of the loan investment and the liability after the change in
interest rates?

The market value of the loan declined by $2,551,830.92 million, to $97.448 million.
MVA = $10,000,000*PVIFA n=2, i=11.5% + $100,000,000* PVIFn=2, i=11.5% = $97,448,169.08

The market value of the note declined $1,232,876.71 to $88.767 million.


MVL = $97,200,000* PVIFn=1, i=9.5% = $88,767,123.29

b. What impact did these changes in market value have on the market value of the equity?

E = A - L = -$2,551,830.92 (-$1,232,876.71) = -$1,313,954.21.

The increase in interest rates caused the asset to decrease in value more than the liability
which caused the value of the net worth to decrease by $1,313,954.21.
c. What was the duration of the loan investment and the liability at the time of issuance?

The duration of the loan investment is 1.909 years. Note: The calculation for this loan is
shown in problem 2, second example. The duration of the liability is one year since it is a
zero-coupon note.

d. Use these duration values to calculate the expected change in the value of the loan and
the liability for the predicted increase of 1.5 percent in interest rates.

The approximate change in the market value of the loan for a 150 basis points change is:
.015
MV A 1.909 * * $100 ,000,000 $2,603,181.82 . The expected market value of
1.10
the loan using the above formula is $97,396,818.18, or $97.400 million.

The approximate change in the market value of the note for a 150 basis points change is:
.015
MVL 1.0 * * $90,000,000 $1,250 ,000.00 . The expected market value of the
1.08
note using the above formula is $88,750,000, or $88.750 million.

e. What was the duration gap of Hands Insurance Company after the issuance of the asset
and note?

The leverage-adjusted duration gap was [1.909 (0.9)1.0] = 1.009 years.

f. What was the change in equity value forecast by this duration gap for the predicted
increase in interest rates of 1.5 percent?

MVE = -1.009*[0.015/(1.10)]*$100,000,000 = -$1,375,909. Note that this calculation


assumes that the change in interest rates is relative to the rate on the loan. Further, this
estimated change in net worth compares with the estimates above in part (d) as follows:
MVE = MV A - MVL = -$2,603,182 (-$1,250,000) = -$1,353,182.

105
g. If the interest rate prediction had been available during the time period in which the
loan and the liability were being negotiated, what suggestions would you offer to
reduce the possible effect on the equity of the company? What are the difficulties in
implementing your ideas?

Obviously the duration of the loan could be shortened relative to the liability, or the
liability duration could be lengthened relative to the loan, or some combination of both.
Shortening the loan duration would mean the possible use of variable rates, or some earlier
payment of principal as was demonstrated in problem 10. The duration of the liability can
not be lengthened without extending the maturity life of the note. In either case, the loan
officer may have been up against market or competitive constraints in that the borrower or
investor may have had other options. Other methods to reduce the interest rate risk under
conditions of this nature include using derivatives such as options, futures, and swaps.

22. The following balance sheet information is available (amounts in $ thousands and duration
in years) for a financial institution:
Amount Duration
T-bills $90 0.50
T-notes 55 0.90
T-bonds 176 x
Loans 2,274 7.00
Deposits 2,092 1.00
Federal funds 238 0.01
Equity 715

Treasury bonds are 5-year maturities paying 6 percent semiannually and selling at par.

a. What is the duration of the T-bond portfolio? 4.393 years as shown below.

Treasury Bond
Par value = $176 Coupon = 0.06 Semiannual payments
YTM = 0.06 Maturity = 5
Time Cash Flow PVIF PV of CF PV*CF*T
0.5 $5.28 0.97087 $5.13 $2.56
1 $5.28 0.94260 $4.98 $4.98
1.5 $5.28 0.91514 $4.83 $7.25
2 $5.28 0.88849 $4.69 $9.38
2.5 $5.28 0.86261 $4.55 $11.39
3 $5.28 0.83748 $4.42 $13.27
3.5 $5.28 0.81309 $4.29 $15.03
4 $5.28 0.78941 $4.17 $16.67
4.5 $5.28 0.76642 $4.05 $18.21
5 $181.28 0.74409 $134.89 $674.45 .
Price = $176.00
Numerator = $773.18 Duration = 4.3931 = Numerator/Price

106
b. What is the average duration of all the assets?

[(.5)(90) + (.9)(55) + (4.393)(176) + (7)(2724)]/3045 = 6.55 years

c. What is the average duration of all the liabilities?

[(1)(2092) + (0.01)(238)]/2330 = 0.90 years

d. What is the leverage-adjusted duration gap? What is the interest rate risk exposure?

DG = DA - kDL = 6.55 - (2330/3045)(0.90) = 5.86 years


The duration gap is positive, indicating that an increase in interest rates will lead to a
decline in net worth.

e. What is the forecasted impact on the market value of equity caused by a relative
upward shift in the entire yield curve of 0.5 percent [i.e., R/(1+R) = 0.0050]?

The market value of the equity will change by the following:

MVE = -DG * (A) * R/(1 + R) = -5.86(3045)(0.0050) = -$89.22. The loss in equity of


$89,220 will reduce the equity (net worth) to $625,780.

f. If the yield curve shifted downward by 0.25 percent (i.e., R/(1+R) = -0.0025), what is
the forecasted impact on the market value of equity?

The change in the value of equity is MV E = -5.86(3045)(-0.0025) = $44,610. Thus, the


market value of equity (net worth) will increase by $44,610, to $759,610.

g. What variables are available to the financial institution to immunize the balance sheet?
How much would each variable need to change to get DGAP equal to 0?

Immunization requires the bank to have a leverage-adjusted duration gap of 0.0. Therefore,
the FI could reduce the duration of its assets to 0.6887 years by using more T-bills and
floating rate loans. Or the FI could try to increase the duration of its deposits possibly by
using fixed-rate CDs with a maturity of 3 or 4 years. Finally, the FI could use a
combination of reducing asset duration and increasing liability duration in such a manner
that LADG is 0.0. This duration gap of 5.86 years is quite large and it is not likely that the
FI will be able to reduce it to zero by using only balance sheet adjustments. For example,
even if the FI moved all of its loans into T-bills, the duration of the assets still would
exceed the duration of the liabilities after adjusting for leverage. This adjustment in asset
mix would imply foregoing a large yield advantage from the loan portfolio relative to the
T-bill yields in most economic environments.

23. Assume that a goal of the regulatory agencies of financial institutions is to immunize the
ratio of equity to total assets, that is, (E/A) = 0. Explain how this goal changes the
desired duration gap for the institution. Why does this differ from the duration gap

107
necessary to immunize the total equity? How would your answers change to part (h) in
problem 20, or part (g) in problem 22, if immunizing equity to total assets was the goal?

In this case the duration of the assets and liabilities should be equal. Thus if E = A, then by
definition the leveraged adjusted duration gap is positive, since E would exceed kA by the
amount of (1 k), and the FI would face the risk of increases in interest rates. In reference to
problems 20 and 22, the adjustments on the asset side of the balance sheet would not need to be
as strong, although the difference likely would not be large if the FI in question is a depository
institution such as a bank or S&L.

24. Identify and discuss three criticisms of using the duration model to immunize the portfolio
of a financial institution.

The three criticisms are:


a Immunization is a dynamic problem because duration changes over time. Thus, it is
necessary to rebalance the portfolio as the duration of the assets and liabilities change
over time.
b Duration matching can be costly because it is not easy to restructure the balance sheet
periodically, especially for large FIs.
c Duration is not an appropriate tool for immunizing portfolios when the expected
interest rate changes are large because of the existence of convexity. Convexity exists
because the relationship between bond price changes and interest rate changes is not
linear, which is assumed in the estimation of duration. Using convexity to immunize a
portfolio will reduce the problem.

25. In general, what changes have occurred in the financial markets that would allow financial
institutions to restructure their balance sheets more rapidly and efficiently to meet desired
goals? Why is it critical for an investment manager who has a portfolio immunized to
match a desired investment horizon to rebalance the portfolio periodically? Why is
convexity a desirable feature to be captured in a portfolio of assets? What is convexity?

The growth of purchased funds markets, asset securitization, and loan sales markets have
increased considerably the speed of major balance sheet restructurings. Further, as these markets
have developed, the cost of the necessary transactions has also decreased. Finally, the growth
and development of the derivative markets provides significant alternatives to managing the risk
of interest rate movements only with on-balance sheet adjustments.

Assets approach maturity at a different rate of speed than the duration of the same assets
approaches zero. Thus, after a period of time, a portfolio or asset that was immunized against
interest rate risk will no longer be immunized. In fact, portfolio duration will exceed the
remaining time in the investment or target horizon, and changes in interest rates could prove
costly to the institution.

Convexity is a property of fixed-rate assets that reflects nonlinearity in the reflection of price-rate
relationships. This characteristic is similar to buying insurance to cover part of the interest rate

108
risk faced by the FI. The more convex is a given asset, the more insurance against interest rate
changes is purchased.

26. A financial institution has an investment horizon of 2 years, 9.5 months. The institution
has converted all assets into a portfolio of 8 percent, $1,000, 3-year bonds that are trading
at a YTM of 10 percent. The bonds pay interest annually. The portfolio manager believes
that the assets are immunized against interest rate changes.

a. Is the portfolio immunized at the time of bond purchase? What is the duration of the
bonds?

Three-year Bonds
Par value = $1,000 Coupon = 0.08 Annual payments
YTM = 0.10 Maturity = 3
Time Cash Flow PVIF PV of CF PV*CF*T
1 $80.00 0.90909 $72.73 $72.73 PVIF = 1/(1+YTM)^(Time)
2 $80.00 0.82645 $66.12 $132.23
3 $1,080 0.75131 $811.42 $2,434.26
Price = $950.26
Numerator = $2,639.22 Duration = 2.7774 = Numerator/Price

The bonds have a duration of 2.7774 years, which is 33.33 months. For practical purposes,
the bond investment horizon was immunized at the time of purchase.

b. Will the portfolio be immunized one year later?

After one year, the investment horizon will be 1 year, 9.5 months. At this time, the bonds
will have a duration of 1.9247 years, or 1 year, 11+ months. Thus the bonds will no longer
be immunized.

Two-year Bonds
Par value = $1,000 Coupon = 0.08 Annual payments
YTM = 0.10 Maturity = 3
Time Cash Flow PVIF PV of CF PV*CF*T
1 $80.00 0.90909 $72.73 $72.73 PVIF = 1/(1+YTM)^(Time)
2 $1,080 0.82645 $892.56 $1,785.12
Price = $965.29
Numerator = $1,857.85 Duration = 1.9247 = Numerator/Price

c. Assume that one-year, 8 percent zero-coupon bonds are available in one year. What
proportion of the original portfolio should be placed in zeros to rebalance the portfolio?

The investment horizon is 1 year, 9.5 months, or 21.5 months. Thus, the proportion of
bonds that should be placed in the zeros can be determined by the following analysis:

109
21.5 months = X*12 months + (1-X)*23 months X = 13.6 percent
Thus 13.6 percent of the bond portfolio should be placed in the zeros after one year.

The following questions and problems are based on material in Appendix 9A to the chapter.

27. MLK Bank has an asset portfolio that consists of $100 million of 30-year, 8 percent
coupon, $1,000 bonds that sell at par.

a. What will be the bonds new prices if market yields change immediately by 0.10
percent? What will be the new prices if market yields change immediately by 2.00
percent?

At +0.10%: Price = $80*PVIFA n=30, i=8.1% + $1,000* PVIFn=30, i=8.1% = $988.85


At 0.10%: Price = $80*PVIFA n=30, i=7.9% + $1,000* PVIFn=30, i=7.9% = $1,011.36

At +2.0%: Price = $80*PVIFA n=30, i=10% + $1,000* PVIFn=30, i=10% = $811.46


At 2.0%: Price = $80*PVIFA n=30, i=6.0% + $1,000* PVIFn=30, i=6.0% = $1,275.30

b. The duration of these bonds is 12.1608 years. What are the predicted bond prices in
each of the four cases using the duration rule? What is the amount of error between the
duration prediction and the actual market values?

P = -D*[R/(1+R)]*P

At +0.10%: P = -12.1608*0.001/1.08*$1,000 = -$11.26 P = $988.74


At -0.10%: P = -12.1608*-0.001/1.08*$1,000 = $11.26 P = $1,011.26

At +2.0%: P = -12.1608*0.02/1.08*$1,000 = -$225.20 P = $774.80


At -2.0%: P = -12.1608*-0.02/1.08*$1,000 = $225.20 P = $1,225.20

Price Price
Market Duration Amount
Determined Estimation of Error
At +0.10%: $988.85 $988.74 $0.11
At -0.10%: $1,011.36 $1,011.26 $0.10

At +2.0%: $811.46 $774.80 $36.66


At -2.0%: $1,275.30 $1,225.20 $50.10

c. Given that convexity is 212.4, what are the bond price predictions in each of the four
cases using the duration plus convexity relationship? What is the amount of error in
these predictions?

P = {-D*[R/(1+R)] + *CX*(R)2}*P

At +0.10%: P = {-12.1608*0.001/1.08 + 0.5*212.4*(0.001)2}*$1,000 = -$11.15

110
At -0.10%: P = {-12.1608*-0.001/1.08 + 0.5*212.4*(-0.001) }*$1,000 = $11.366
2

At +2.0%: P = {-12.1608*0.02/1.08 + 0.5*212.4*(0.02)2}*$1,000 = -$182.72


At -2.0%: P = {-12.1608*-0.02/1.08 + 0.5*212.4*(-0.02) 2}*$1,000 = $267.68

Price Price
Price Duration & Duration &
Market Convexity Convexity Amount
Determined Estimation Estimation of Error
At +0.10%: $988.85 -$11.15 $988.85 $0.00
At -0.10%: $1,011.36 $11.37 $1,011.37 $0.01

At +2.0%: $811.46 -$182.72 $817.28 $5.82


At -2.0%: $1,275.30 $267.68 $1,267.68 $7.62

d. Diagram and label clearly the results in parts (a), (b) and (c).

Rate-Price Relationships

$1,400

$1,275.30 Actual Market Price


$1,225.20

Duration Profile

$1,000

The duration and convexity profile


is virtually on the actual market $811.46
price profile, and thus is barely $774.80
visible in the graph.

$600
4 6 8 10 12
Percent Yield-to-Maturity

The profiles for the estimates based on only 0.10 percent changes in rates are very close
together and do not show clearly in a graph. However, the profile relationship would be
similar to that shown above for the 2.0 percent changes in market rates.

111
28. Estimate the convexity for each of the following three bonds all of which trade at YTM of
8 percent and have face values of $1,000.

A 7-year, zero-coupon bond.


A 7-year, 10 percent annual coupon bond.
A 10-year, 10 percent annual coupon bond that has a duration value of 6.994 (7) years.

Market Value Market Value Capital Loss + Capital Gain


at 8.01 percent at 7.99 percent Divided by Original Price
7-year zero -0.37804819 0.37832833 0.00000048
7-year coupon -0.55606169 0.55643682 0.00000034
10-year coupon -0.73121585 0.73186329 0.00000057
8
Convexity = 10 * (Capital Loss + Capital Gain) Original Price at 8.00 percent

7-year zero CX = 100,000,000*0.00000048 = 48


7-year coupon CX = 100,000,000*0.00000034 = 34
10-year coupon CX = 100,000,000*0.00000057 = 57

An alternative method of calculating convexity for these three bonds using the following
equation is illustrated at the end of this problem and onto the following page.
1 n
CFt
Convexity 2
*
P * (1R ) t 1 (1R )
t
* t * (1 t )

Rank the bonds in terms of convexity, and express the convexity relationship between
zeros and coupon bonds in terms of maturity and duration equivalencies.

Ranking, from least to most convexity: 7-year coupon bond, 7-year zero, 10-year coupon

Convexity relationships:
Given the same yield-to-maturity, a zero-coupon bond with the same maturity as a coupon
bond will have more convexity.

Given the same yield-to-maturity, a zero-coupon bond with the same duration as a coupon
bond will have less convexity.

Zero Coupon Bond


Par value = $1,000 Coupon = 0
YTM = 0.08 Maturity = 7
Time Cash Flow PVIF PV of CF PV*CF*T *(1+T) *(1+R)^2
1 $0.00 0.92593 $0.00 $0.00 $0.00
2 $0.00 0.85734 $0.00 $0.00 $0.00

112
3 $0.00 0.79383 $0.00 $0.00 $0.00
4 $0.00 0.73503 $0.00 $0.00 $0.00
5 $0.00 0.68058 $0.00 $0.00 $0.00
6 $0.00 0.63017 $0.00 $0.00 $0.00
7 1,000.00 0.58349 $583.49 4,084.43 32,675.46
Price = $583.49 32,675.46 680.58
Numerator = $4,084.43 Duration = 7.0000
Convexity = 48.011
7-year Coupon Bond
Par value = $1,000 Coupon = 0.1
YTM = 0.08 Maturity = 7
Time Cash Flow PVIF PV of CF PV*CF*T *(1+T) *(1+R)^2
1 $100.00 0.925926 $92.59 $92.59 185.19
2 $100.00 0.85734 $85.73 $171.47 514.40
3 $100.00 0.79383 $79.38 $238.15 952.60
4 $100.00 0.73503 $73.50 $294.01 1,470.06
5 $100.00 0.68058 $68.06 $340.29 2,041.75
6 $100.00 0.63017 $63.02 $378.10 2,646.71
7 1,100.00 0.58349 $641.84 $4,492.88 35,943.01
Price = $1,104.13 43,753.72 1287.9
Numerator = $6,007.49 Duration = 5.4409
Convexity = 33.974
10-year Coupon Bond
Par value = $1,000 Coupon = 0.1
YTM = 0.08 Maturity = 10
Time Cash Flow PVIF PV of CF PV*CF*T *(1+T) *(1+R)^2
1 $100.00 0.925926 $92.59 $92.59 185.19
2 $100.00 0.857339 $85.73 $171.47 514.40
3 $100.00 0.793832 $79.38 $238.15 952.60
4 $100.00 0.735030 $73.50 $294.01 1470.06
5 $100.00 0.680583 $68.06 $340.29 2041.75
6 $100.00 0.630170 $63.02 $378.10 2646.71
7 $100.00 0.583490 $58.35 $408.44 3267.55
8 $100.00 0.540269 $54.03 $432.22 3889.94
9 $100.00 0.500249 $50.02 $450.22 4502.24
10 $1,100.0 0.463193 $509.51 5,095.13 56046.41
Price = 1,134.20 75516.84 1322.9
Numerator = 7,900.63 Duration = 6.9658
Convexity = 57.083
29. A 10-year, 10 percent annual coupon, $1,000 bond trades at a YTM of 8 percent. The bond
has a duration of 6.994 years. What is the modified duration of this bond? What is the

113
practical value of calculating modified duration? Does modified duration change the result
in using the duration relationship to estimate price sensitivity?

Modified duration = Duration/(1+ R) = 6.994/1.08 = 6.4759. Some practitioners find this


value easier to use because the percentage change in value can be estimated simply by
multiplying the existing value times the basis point change in interest rates rather than by
the relative change in interest rates. Using modified duration will not change the estimated
price sensitivity of the asset.

Additional Examples for Chapter 9


This example is to estimate both the duration and convexity of a 6-year bond paying 5 percent
coupon annually and the annual yield to maturity is 6 percent.

6-year Coupon Bond


Par value = $1,000 Coupon = 0.05
YTM = 0.06 Maturity = 6
Time Cash Flow PVIF PV of CF PV*CF*T *(1+T) *(1+R)^2
1 $50.00 0.94340 $47.17 $47.17 $94.34
2 $50.00 0.89000 $44.50 $89.00 $267.00
3 $50.00 0.83962 $41.98 $125.94 $503.77
4 $50.00 0.79209 $39.60 $158.42 $792.09
5 $50.00 0.74726 $37.36 $186.81 1,120.89
6 $1,050.00 0.70496 $740.21 $4,441.25 31,088.76
Price = $950.83 33,866.85 1068.3
Numerator = $5,048.60 Duration = 5.3097
Convexity = 31.7

Using the textbook method:


CX = 108 [(950.3506-950.8268)/950.8268 + (951.3032-950.8268)/950.8268]
= 108[-0.0005007559 + 0.0005501073] = 31.70

What is the effect of a 2 percent increase in interest rates, from 6 percent to 8 percent?

Using Present Values, the percentage change is:


= ($950.8268 - $861.3136)/ $950.8268 = -9.41%

Using the duration formula: MVA = -D*R/(1 + R) + 0.5CX(R)2


= -5.3097*[(0.02)/1.06] + 0.5(31.7)(0.02)2
= -0.1002 + .0063 = -9.38%
Adding convexity adds more precision. Duration alone would have given the answer of -10.02%.

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Chapter Ten
Market Risk
Chapter Outline

Introduction

Market Risk Measurement

Calculating Market Risk Exposure

The RiskMetrics Model


The Market Risk of Fixed-Income Securities
Foreign Exchange
Equities
Portfolio Aggregation

Historic or Back Simulation


The Historic (Back Simulation) Model versus RiskMetrics
The Monte Carlo Simulation Approach

Regulatory Models: The BIS Standardized Framework


Fixed Income
Foreign Exchange
Equities

The BIS Regulations and Large Bank Internal Models

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter Ten

1. What is meant by market risk?

Market risk is the uncertainty of the effects of changes in economy-wide systematic factors that
affect earnings and stock prices of different firms in a similar manner. Some of these market-
wide risk factors include volatility, liquidity, interest-rate and inflationary expectation changes.

2. Why is the measurement of market risk important to the manager of a financial institution?

Measurement of market risk can help an FI manager in the following ways:


a. Provide information on the risk positions taken by individual traders.
b. Establish limit positions on each trader based on the market risk of their portfolios.
c. Help allocate resources to departments with lower market risks and appropriate returns.
d. Evaluate performance based on risks undertaken by traders in determining optimal
bonuses.
e. Help develop more efficient internal models so as to avoid using standardized
regulatory models.

3. What is meant by daily earnings at risk (DEAR)? What are the three measurable
components? What is the price volatility component?

DEAR or Daily Earnings at Risk is defined as the estimated potential loss of a portfolio's value
over a one-day unwind period as a result of adverse moves in market conditions, such as changes
in interest rates, foreign exchange rates, and market volatility. DEAR is comprised of (a) the
dollar value of the position, (b) the price sensitivity of the assets to changes in the risk factor, and
(c) the adverse move in the yield. The product of the price sensitivity of the asset and the
adverse move in the yield provides the price volatility component.

4. Follow Bank has a $1 million position in a five-year, zero-coupon bond with a face value
of $1,402,552. The bond is trading at a yield to maturity of 7.00 percent. The historical
mean change in daily yields is 0.0 percent, and the standard deviation is 12 basis points.

a. What is the modified duration of the bond?

MD = 5 (1.07) = 4.6729 years

b. What is the maximum adverse daily yield move given that we desire no more than a 5
percent chance that yield changes will be greater than this maximum?

Potential adverse move in yield at 5 percent = 1.65= 1.65 x 0.0012 = .001980

c. What is the price volatility of this bond?

Price volatility = -MD x potential adverse move in yield


= -4.6729 x .00198 = -0.009252 or -0.9252 percent

116
d. What is the daily earnings at risk for this bond?

DEAR = ($ value of position) x (price volatility)


= $1,000,000 x 0.009252 = $9,252

5. What is meant by value at risk (VAR)? How is VAR related to DEAR in J.P. Morgans
RiskMetrics model? What would be the VAR for the bond in problem (4) for a 10-day
period? With what statistical assumption is our analysis taking liberties? Could this
treatment be critical?

Value at Risk or VAR is the cumulative DEARs over a specified period of time and is given by

the formula VAR = DEAR x [N] . VAR is a more realistic measure if it requires a longer period
to unwind a position, that is, if markets are less liquid. The value for VAR in problem four
above is $9,252 x 3.1623 = $29,257.39.

The relationship according to the above formula assumes that the yield changes are independent.
This means that losses incurred on one day are not related to the losses incurred the next day.
However, recent studies have indicated that this is not the case, but that shocks are autocorrelated
in many markets over long periods of time.

6. The DEAR for a bank is $8,500. What is the VAR for a 10-day period? A 20-day period?
Why is the VAR for a 20-day period not twice as much as that for a 10-day period?

For the 10-day period: VAR = 8,500 x [10] = 8,500 x 3.1623 = $26,879.36

For the 20-day period: VAR = 8,500 x [20] = 8,500 x 4.4721 = $38,013.16

The reason that VAR20 (2 x VAR10) is because [20] (2 x [10]). The interpretation is that
the daily effects of an adverse event become less as time moves farther away from the event.

7. The mean change in the daily yields of a 15-year, zero-coupon bond has been five basis
points (bp) over the past year with a standard deviation of 15 bp. Use these data and
assume the yield changes are normally distributed.

a. What is the highest yield change expected if a 90 percent confidence limit is required;
that is, adverse moves will not occur more than one day in 20?

If yield changes are normally distributed, 90 percent of the area of a normal distribution
will be 1.65 standard deviations (1.65) from the mean for a one-tailed distribution. In this
example, it means 1.65 x 15 = 24.75 bp. Thus, the maximum adverse yield change
expected for this zero-coupon bond is an increase of 24.75 basis points in interest rates.

b. What is the highest yield change expected if a 95 percent confidence limit is required?

If a 95 percent confidence limit is required, then 95 percent of the area will be 1.96
standard deviations (1.96) from the mean. Thus, the maximum adverse yield change

117
expected for this zero-coupon bond is an increase of 29.40 basis points (1.96 x 15) in
interest rates.

8. In what sense is duration a measure of market risk?

The market risk calculations typically are based on the trading portion of an FIs fixed-rate asset
portfolio because these assets must reflect changes in value as market interest rates change. As
such, duration or modified duration provides an easily measured and usable link between
changes in the market interest rates and the market value of fixed-income assets.

9. Bank Alpha has an inventory of AAA-rated, 15-year zero-coupon bonds with a face value
of $400 million. The bonds currently are yielding 9.5% in the over-the-counter market.

a. What is the modified duration of these bonds?

Modified duration = (MD) = D/(1 + r) = 15/(1.095) = -13.6986.

b. What is the price volatility if the potential adverse move in yields is 25 basis points?

Price volatility = (-MD) x (potential adverse move in yield)


= (-13.6986) x (.0025) = -0.03425 or -3.425 percent.

c. What is the DEAR?

Daily earnings at risk (DEAR) = ($ Value of position) x (Price volatility)


Dollar value of position = 400/(1 + 0.095)15 = $102.5293million. Therefore,
DEAR = $102.5293499 million x -0.03425 = -$3.5116 million, or -$3,511,630.

d. If the price volatility is based on a 90 percent confidence limit and a mean historical
change in daily yields of 0.0 percent, what is the implied standard deviation of daily
yield changes?

The potential adverse move in yields (PAMY) = confidence limit value x standard
deviation value. Therefore, 25 basis points = 1.65 x , and = .0025/1.65 = .001515 or
15.15 basis points.

10. Bank Two has a portfolio of bonds with a market value of $200 million. The bonds have
an estimated price volatility of 0.95 percent. What are the DEAR and the 10-day VAR for
these bonds?

Daily earnings at risk (DEAR) = ($ Value of position) x (Price volatility)


= $200 million x .0095
= $1.9million, or $1,900,000

Value at risk (VAR) = DEAR x N = $1,900,000 x 10


= $1,900,000 x 3.1623 = $6,008,327.55

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11. Bank of Southern Vermont has determined that its inventory of 20 million euros ( ) and 25
million British pounds () is subject to market risk. The spot exchange rates are $0.40/
and $1.28/, respectively. The s of the spot exchange rates of the and , based on the
daily changes of spot rates over the past six months, are 65 bp and 45 bp, respectively.
Determine the banks 10-day VAR for both currencies. Use adverse rate changes in the
th
95 percentile.

FX position of = 20m x 0.40 = $8 million


FX position of = 25m x 1.28 = $32 million

FX volatility = 1.65 x 65bp = 107.25, or 1.0725%


FX volatility = 1.65 x 45bp = 74.25, or 0.7425%

DEAR = ($ Value of position) x (Price volatility)

DEAR of = $8m x .010725 = $0.0860m, or $85,800


DEAR of = $32m x .007425 = $0.2376m, or $237,600

VAR of = $138,000 x 10 = $85,800 x 3.1623 = $271,323.42


VAR of = $237,600 x 10 = $237,600 x 3.1623 = $751,357.17

12. Bank of Alaskas stock portfolio has a market value of $10,000,000. The beta of the
portfolio approximates the market portfolio, whose standard deviation (m) has been
estimated at 1.5 percent. What is the 5-day VAR of this portfolio, using adverse rate
th
changes in the 99 percentile?

DEAR = ($ Value of portfolio) x (2.33 x m ) = $10m x (2.33 x .015)


= $10m x .03495 = $0.3495m or $349,500

VAR = $349,500 x 5 = $349,500 x 2.2361 = $781,505.76

13. Jeff Resnick, vice president of operations of Choice Bank, is estimating the aggregate
DEAR of the banks portfolio of assets consisting of loans (L), foreign currencies (FX),
and common stock (EQ). The individual DEARs are $300,700, $274,000, and $126,700
respectively. If the correlation coefficients ij between L and FX, L and EQ, and FX and
EQ are 0.3, 0.7, and 0.0, respectively, what is the DEAR of the aggregate portfolio?

119
0. 5

( DEARL ) ( DEARFX ) (DEAREQ )
2 2 2


( 2L, FX x DEARL x DEARFX )
DEAR portfolio
( 2L, EQ x DEARL x DEAR EQ )

( 2FX ,EQ x DEARFX x DEAR EQ )

0. 5

$300,700 2 $274,000 2 $126 ,700 2 2(0.3)($300 ,700)($ 274,000)

2(0.7)($ 300,700 )($126 ,700 ) 2(0.0)($274,000 )($126 ,700)


$284,322,626 ,000 $533,219
0. 5

14. Calculate the DEAR for the following portfolio with and without the correlation
coefficients.
Estimated
Assets DEAR S,FX S,B FX,B
Stocks (S) $300,000 -0.10 0.75 0.20
Foreign Exchange (FX) $200,000
Bonds (B) $250,000
0. 5
( DEARS ) 2 ( DEARFX ) 2 (DEARB ) 2

( 2S , FX x DEARS x DEARFX )
DEAR portfolio
( 2 x DEAR x DEAR )
S, B S B


( 2 FX , B x DEAR FX x DEAR B )

0. 5

$300,000 2 $200,000 2 $250 ,000 2 2(0.1)($300 ,000)($ 200,000)

2(0.75)($300 ,000)($ 250,000) 2( 0.20)($200 ,000)($ 250,000)


$312,000,000 ,000 $559,464
0. 5

What is the amount of risk reduction resulting from the lack of perfect positive correlation
between the various assets groups?

The DEAR for a portfolio with perfect correlation would be $750,000. Therefore the risk
reduction is $750,000 - $559,464 = $190,536.

15. What are the advantages of using the back simulation approach to estimate market risk?
Explain how this approach would be implemented.

The advantages of the back simulation approach to estimating market risk are that (a) it is a
simple process, (b) it does not require that asset returns be normally distributed, and (c) it does

120
not require the calculation of correlations or standard deviations of returns. Implementation
requires the calculation of the value of the current portfolio of assets based on the prices or yields
that were in place on each of the preceding 500 days (or some large sample of days). These data
are rank-ordered from worst case to best and percentile limits are determined. For example, the
five percent worst case provides an estimate with 95 percent confidence that the value of the
portfolio will not fall more than this amount.

16. Export Bank has a trading position in Japanese Yen and Swiss Francs. At the close of
business on February 4, the bank had 300,000,000 and Sf10,000,000. The exchange rates
for the most recent six days are given below:

Exchange Rates per U.S. Dollar at the Close of Business


2/4 2/3 2/2 2/1 1/29 1/28
Japanese Yen 112.13 112.84 112.14 115.05 116.35 116.32
Swiss Francs 1.4140 1.4175 1.4133 1.4217 1.4157 1.4123

a. What is the foreign exchange (FX) position in dollar equivalents using the FX rates on
February 4?

Japanese Yen: 300,000,000/112.13 = $2,675,465.98


Swiss Francs: Swf10,000,000/Swf1.414 = $7,072,135.78

b. What is the definition of delta as it relates to the FX position?

Delta measures the change in the dollar value of each FX position if the foreign currency
depreciates by 1 percent against the dollar.

c. What is the sensitivity of each FX position; that is, what is the value of delta for each
currency on February 4?

Japanese Yen: 1.01 x current exchange rate = 1.01 x 112.13 = 113.2513/$


Revalued position in $s = 300,000,000/113.2513 = $2,648,976.21
Delta of $ position to Yen = $2,648,976.21 - $2,675,465.98
= -$26,489.77

Swiss Francs: 1.01 x current exchange rate = 1.01 x Swf1.414 = Swf1.42814


Revalued position in $s = Swf10,000,000/1.42814 = $7,002,114.64
Delta of $ position to Swf = $7,002,114.64 - $7,072,135.78
= -$70,021.14

d. What is the daily percentage change in exchange rates for each currency over the five-
day period?

Day Japanese Yen: Swiss Franc


2/4 -0.62921% -0.24691% % Change = (Ratet/Rate t-1) - 1 * 100
2/3 0.62422% 0.29718%

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2/2 -2.52934% -0.59084%
2/1 -1.11732% 0.42382%
1/29 0.02579% 0.24074%

e. What is the total risk faced by the bank on each day? What is the worst-case day?
What is the best-case day?

Japanese Yen Swiss Francs Total


Day Delta % Rate Risk Delta % Rate Risk Risk
2/4 -$26,489.77 -0.6292% $166.68 -$70,021.14 -0.2469% $172.88 $339.56
2/3 -$26,489.77 0.6242% -$165.35 -$70,021.14 0.2972% -$208.10 -$373.45
2/2 -$26,489.77 -2.5293% $670.01 -$70,021.14 -0.5908% $413.68 $1,083.69
2/1 -$26,489.77 -1.1173% $295.97 -$70,021.14 0.4238% -$296.75 -$0.78
1/29 -$26,489.77 0.0258% -$6.83 -$70,021.14 0.2407% -$168.54 -$175.37

The worst-case day is February 3, and the best-case day is February 2.

f. Assume that you have data for the 500 trading days preceding February 4. Explain how
you would identify the worst-case scenario with a 95 percent degree of confidence?

The appropriate procedure would be to repeat the process illustrated in part (e) above for all
500 days. The 500 days would be ranked on the basis of total risk from the worst-case to
the best-case. The fifth percentile from the absolute worst-case situation would be day 25
in the ranking.

g. Explain how the five percent value at risk (VAR) position would be interpreted for
business on February 5.

Management would expect with a confidence level of 95 percent that the total risk on
February 5 would be no worse than the total risk value for the 25th worst day in the
previous 500 days. This value represents the VAR for the portfolio.

h. How would the simulation change at the end of the day on February 5? What variables
and/or processes in the analysis may change? What variables and/or processes will not
change?

The analysis can be upgraded at the end of the each day. The values for delta may change
for each of the assets in the analysis. As such, the value for VAR may also change.

17. What is the primary disadvantage to the back simulation approach in measuring market
risk? What affect does the inclusion of more observation days have as a remedy for this
disadvantage? What other remedies are possible to deal with the disadvantage?

The primary disadvantage of the back simulation approach is the confidence level contained in
the number of days over which the analysis is performed. Further, all observation days typically
are given equal weight, a treatment that may not reflect accurately changes in markets. As a

122
result, the VAR number may be biased upward or downward depending on how markets are
trending. Possible adjustments to the analysis would be to give more weight to more recent
observations, or to use Monte Carlo simulation techniques.

18. How is Monte Carlo simulation useful in addressing the disadvantages of back simulation?
What is the primary statistical assumption underlying its use?

Monte Carlo simulation can be used to generate additional observations that more closely
capture the statistical characteristics of recent experience. The generating process is based on the
historical variance-covariance matrix of FX changes. The values in this matrix are multiplied by
random numbers that produce results that pattern closely the actual observations of recent
historic experience.

19. In the BIS Standardized Framework for regulating risk exposure for the fixed-income
portfolios of banks, what do the terms specific risk and general market risk mean? Why
does the capital charge for general market risk tend to underestimate the true interest rate or
price risk exposure? What additional offsets, or disallowance factors, are included in the
analysis?

Specific risk is the risk unique to the issuing party for long-term bonds in the trading portfolio of
a financial institution. Specific risk measures the decline in the liquidity or credit risk quality of
the portfolio. General market risk measures reflect the product of duration and possible interest
rate shocks to determine the sensitivity of the portfolio to market rate movements.

The capital charge for market risk tends to underestimate interest rate risk because of (a)
maturity timing differences in offsetting securities in the same time band, and (b) basis point risk
for different risk assets that may not be affected in a similar manner by interest rate changes.
Thus the capital charges may be adjusted for basis risk. These adjustments also reflect the use of
excess positions in one time zone to partially offset positions in another time band.

20. An FI has the following bonds in its portfolio: long 1-year U.S. Treasury bills, short 3-year
Treasury bonds, long 3-year AAA-rated corporate bonds, and long 12-year B-rated
(nonqualifying) bonds worth $40, $10, $25, and $10 million, respectively (market values).
Using Table 10-5, determine the following:

a. Charges for specific risk = $1.20 million (See below.)

AAA = Qualifying bonds; B = Nonqualifying bonds

Time Specific Risk General Market Risk


band Issue Position Weight% Charge Weight% Charge
1 year Treasury bill $40m 0.00 0.00 1.25 0.5000
3-year Treasury bond ($10m) 0.00 0.00 2.25 (0.2250)
3-year AAA - rated $25m 1.60 0.40 2.25 0.5625
12-year BB - rated $10m 8.0 0.80 4.50 0.4500
1.20 1.2875

123
b. Charges for general market risk.

General market risk charges = $1.2875 million (From table above.)

c. Charges for basis risk: vertical offsets within same time-bands only (i.e., ignoring
horizon effects).

Time-band Longs Shorts Residuals Offset Disallowance Charge


3-year $0.5625m ($0.225m) ($0.3375m) $0.2250m 10% $0.0225m

d. What is the total capital charge, using the information from parts (a) through (c)?

Total capital charges = $1.20m + $1.2875 + $0.0225m = $2.51 million

21. Explain how the capital charge for foreign exchange risk is calculated in the BIS
Standardized model. If an FI has an $80 million long position in Euros, a $40 million short
position in British pounds, and a $20 million long position in Swiss francs, what would be
the capital charge required against FX market risk?

Total long position = $80 m of Euros + $20 m of Swiss franks = $100 million
Total short position = $40 million British pounds
Higher of long or short position = $100 million
Capital charge = 0.08 x $100 = $8 million

22. Explain the BIS capital charge calculation for unsystematic and systematic risk for an FI
that holds various amounts of equities in its portfolio. What would be the total capital
charge required for an FI that holds the following portfolio of stocks? What criticisms can
be levied against this treatment of measuring the risk in the equity portfolio?

Company Long Short


Texaco $45 million $25 million
Microsoft $55 million $12 million
Robeco $20 million
Cifra $15 million

The capital charge against common shares consists of two parts: those for unsystematic risk (x-
factor) and those for systematic risk (y-factor). Unsystematic risk is unique to the firm in the
capital asset pricing model sense. The risk charge is found by multiplying a four percent risk
charge times the total (not net) of the long and short positions.

Charges against unsystematic risk or firm-specific risk:

Gross position in all stocks = $45 + $55 + $20 + $25 + $12 + $15 = $172 million
Capital charges = 4 percent x $172m = $6.88m, or $6,880,000

124
Systematic risk refers to market risk. The capital charge is found by multiplying the net long or
short position by eight percent.

Charges against systematic risk or market risk:

Net Positions Texaco $20m


Microsoft $43m
Robeco $20m
Cifra $15m
Total $98m

Capital charges = 8 percent x $98m = $7.84m, or $7,840,000

Total capital charges = $6.88m + $7.84m = $14.72m, or $14,720,000

This approach assumes that each stock has the same amount of systematic risk, and that no
benefits of diversification exist.

23. What conditions were introduced by BIS in 1998 to allow large banks to use internally
generated models for the measurement of market risk? What types of capital can be held to
meet the capital charge requirements?

Large banks are allowed to utilize internally generated models to measure market risk after
receiving approval from the regulators. The models must consider a 99 percent confidence level,
the minimum holding period for VAR estimates is 10 days, and the average estimated VAR will
be multiplied by a minimum factor of 3. Further, the minimum capital charge must be the higher
of the previous days VAR or the average VAR over the previous 60 days. Thus calculation of
the capital charge is more conservative.

However, FIs are allowed to hold three types of capital to meet this more conservative
requirement. First, Tier I capital includes common equity and retained earnings, Tier II capital
includes long-term subordinated debt with a maturity of over five years, and Tier III capital
includes short-term subordinated debt with a maturity of at least two years.

24. Dark Star Bank has estimated its average VAR for the previous 60 days to be $35.5
million. DEAR for the previous day was $30.2 million.

a. Under the latest BIS standards, what is the amount of capital required to be held for
market risk?

Under the latest BIS standards, the proposed capital charge is the higher of:

Previous days VAR = DEAR x 10 = 30.2 x 10 = $95.5008m


Average VAR x 3 = 35.5 x 3 = $106.5million

Capital charge = Higher of 1 and 2 = $106.5million

125
b. Dark Star has $15 million of Tier 1 capital, $37.5 million of Tier 2 capital, and $55
million of Tier 3 capital. Is this amount of capital sufficient? In not, what minimum
amount of new capital should be raised? Of what type?

Total capital needed = 106.5

Tier 1 + Tier 2 + Tier 3 = $15m + $37.5 + $54m = $106.5m


However, the capital is not sufficient because Tier 3 capital cannot exceed 250% of Tier
1 capital. Thus, Tier 1 capital (X) needs to be:

X + 2.5X = $106.5m - $37.5 = $69m X = 69/3.5 = $19.7143m

If Tier 1 capital is increased by 19.7143 - 15 = $4.7143m, then the capital charge will be
met, for example, $19.7143 + $37.5 + $49.2857 = $106.5m.

126
Chapter 11
Credit Risk: Individual Loan Risk
Chapter Outline

Introduction

Credit Quality Problems

Types of Loans
Commercial and Industrial Loans
Real Estate Loans
Individual (Consumer) Loans
Other Loans

The Return on a Loan


The Contractually Promised Return on a Loan
The Expected Return on a Loan

Retail versus Wholesale Credit Decisions


Retail
Wholesale

Measurement of Credit Risk

Default Risk Models


Qualitative Models
Credit Scoring Models

Newer Models of Credit Risk Measurement and Pricing


Term Structure Derivation of Credit Risk
Mortality Rate Derivation of Credit Risk
RAROC Models
Option Models of Default Risk

Summary

Appendix 11A: CreditMetrics


Rating Migration
Valuation
Calculation of VAR
Capital Requirements

Appendix 11B: Credit Risk

Md. Monjur Morshed


1
Solutions for End-of-Chapter Questions and Problems: Chapter Eleven

1. Why is credit risk analysis an important component of bank risk management? What recent
activities by FIs have made the task of credit risk assessment more difficult for both bank managers
and regulators?

Credit risk management is important for bank managers because it determines several features of a loan:
interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans
are approved. If credit risk analysis is inadequate, default rates could be higher and push a bank into
insolvency, especially if the markets are competitive and the margins are low.

Credit risk management has become more complicated over time because of the increase in off-balance-
sheet activities that create implicit contracts and obligations between prospective lenders and buyers.
Credit risks of some off-balance-sheet products such as loan commitments, options, and interest rate
swaps, are difficult to assess because the contingent payoffs are not deterministic, making the pricing of
these products complicated.

2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate
loan? Why would bankers prefer to charge floating rates, especially for longer-maturity loans?

A secured loan is backed by some of the collateral that is pledged to the lender in the event of default. A
lender has rights to the collateral, which can be liquidated to pay all or part of the loan. In a fixed-rate
loan, the lender of the loan bears the risk of interest rate changes; if interest rates rise, the opportunity cost
of lending is higher. If interest rates fall, the lender benefits. Since it is harder to predict longer-term rates,
FIs prefer to charge floating rates for longer-term bonds and pass the risks on to the borrower.

3. How does a spot loan differ from a loan commitment? What are the advantages and disadvantages
of borrowing through a loan commitment?

A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan
commitment allows a borrower the option to take down the loan any time during a fixed period at a
predetermined rate. This can be advantageous during periods of rising rates in that the borrower can
borrow as needed at a predetermined rate. If the rates decline, the borrower can borrow from other
sources. The disadvantage is the cost: an up-front fee is required in addition to a back-end fee for the
unused portion of the commitment.

4. Why is commercial lending declining in importance in the U.S.? What effect does the decline have
on overall commercial lending activities?

Commercial bank lending has been declining in importance because of disintermediation, a process in
which customers are able to access financial markets directly such as in issuing commercial paper. The
total amount of commercial paper outstanding in the U.S. has grown dramatically over the last decade.
Historically, only the most creditworthy borrowers had access the commercial paper market, but more
middle-market firms and financial institutions now have access to this market. As a consequence of this
growth, the pool of borrowers available to bankers has become smaller and riskier. This makes the credit
assessment and monitoring of loans more difficult.

5. What are the primary characteristics of residential mortgage loans? Why does the ratio of adjustable
rate mortgages to fixed-rate mortgages in the economy vary over the interest rate cycle? When
would the ratio be highest?
2
Residential mortgages contracts differ in size, the ratio of the loan amount to the value of the property, the
maturity of the loan, the rate of interest of the loan, and whether the interest rate is fixed or adjustable. In
addition, mortgage agreements differ in the amount of fees, commissions, discounts, and points that are
paid by the borrower.

The ratio of adjustable rate mortgages to fixed-rate mortgages is lowest when interest rates are low
because borrowers prefer to lock in the low market rates for long periods of time. When rates are high,
the adjustable rate mortgages allow borrowers the potential to realize relief from high interest rates in the
future when rates decline.

6. What are the two major classes of consumer loans at U.S. banks? How do revolving loans differ
from automobile and other consumer installment loans?

Consumer loans can be classified as either nonrevolving or revolving loans. Automobile loans and fixed-
term personal loans usually have a maturity date at which time the loan is expected to have a zero balance,
and thus they are considered to be nonrevolving loans. Revolving loans usually involve credit card debt,
or similar lines of credit, and as a result the balance will rise and fall as borrowers make payments and
utilize the accounts. These accounts typically have maturities of 1 to 3 years, but the accounts normally
are renewed if the payment history is satisfactory. Many banks often recognize high rates of return on
these loans, even though in recent years, banks have faced chargeoff rates in the range of four to eight
percent.

7. How does the credit card transaction process assist in the credit monitoring function of financial
institutions? Which major parties receive a fee in the typical credit card transaction? Do the
services provided warrant the payment of these associated fees?

Credit card transactions typically must be authorized by the cardholders bank. Thus verification of
satisfactory credit quality occurs with each transaction. During the transaction process, fixed fees are
charged to the merchant, the merchants bank, and the card issuer. The fees cover the data processing and
technology services necessary to ensure that the revolving credit transaction process is accomplished.

8. What are compensating balances? What is the relationship between the amount of compensating
balance requirement and the return on the loan to the FI?

A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-
granting depository FI. Thus the funds are not available for use by the borrower. As the amount of
compensating balance for a given loan size increases, the effective return on the loan increases for the
lending institution.

9. County Bank offers one-year loans with a stated rate of 9 percent but requires a compensating
balance of 10 percent. What is the true cost of this loan to the borrower? How does the cost change
if the compensating balance is 15 percent? If the compensating balance is 20 percent?

The true cost is the loan rate (1 compensating balance rate) = 9% (1.0 0.1) = 10 percent. For
compensating balance rates of 15 percent and 20 percent, the true cost of the loan would be 10.59 percent
and 11.25 percent respectively. Note that as the compensating balance rate increases by a constant
amount, the true cost of the loan increases at an increasing rate.

3
10. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25 percent loan
origination fee, imposes a 10 percent compensating balance requirement, and must pay a 6 percent
reserve requirement to the Federal Reserve. The loans typically are repaid at maturity.

a. If the risk premium for a given customer is 2.5 percent, what is the simple promised interest
return on the loan?

The simple promised interest return on the loan is BR + m = 0.09 + 0.025 = 0.115 or 11.5 percent.

b. What is the contractually promised gross return on the loan per dollar lent?

f ( BR m ) 0.0025 ( 0.09 0.025 ) 0.1175


k 1 1 1 1 1 1 12.97 percent
1 [ b(1 RR )] 1 [0.1(1 0.06)] 0.906

c. Which of the fee items has the greatest impact on the gross return?

The compensating balance has the strongest effect on the gross return on the loan. Without the
compensating balance, the gross return would equal 11.75 percent, a reduction of 1.22 percent.
Without the origination fee, the gross return would be 12.69 percent, a reduction of only 0.28
percent. Eliminating the reserve requirement would cause the gross return to increase to 13.06
percent, an increase of 0.09 percent.

11. Why are most retail borrowers charged the same rate of interest, implying the same risk premium or
class? What is credit rationing? How is it used to control credit risks with respect to retail and
wholesale loans?

Most retail loans are small in size relative to the overall investment portfolio of an FI, and the cost of
collecting information on household borrowers is high. As a result, most retail borrowers are charged the
same rate of interest that implies the same level of risk.

Credit rationing involves restricting the amount of loans that are available to individual borrowers. On
the retail side, the amount of loans provided to borrowers may be determined solely by the proportion of
loans desired in this category rather than price or interest rate differences, thus the actual credit quality of
the individual borrowers. On the wholesale side, the FI may use both credit quantity and interest rates to
control credit risk. Typically more risky borrowers are charged a higher risk premium to control credit
risk. However, the expected returns from increasingly higher interest rates that reflect higher credit risk at
some point will be offset by higher default rates. Thus rationing credit through quantity limits will occur
at some interest rate level even though positive loan demand exists at even higher risk premiums.

12. Why could a lenders expected return be lower when the risk premium is increased on a loan? In
addition to the risk premium, how can a lender increase the expected return on a wholesale loan? A
retail loan?

An increase in risk premiums indicates a riskier pool of clients who are more likely to default by taking
on riskier projects. This reduces the repayment probability and lowers the expected return to the lender.
In both cases the lender often is able to charge fees that increase the return on the loan. However, in both
cases also, the fees may become sufficiently high as to increase the risk of nonpayment of default on the
loan.
4
13. What are covenants in a loan agreement? What are the objectives of covenants? How can these
covenants be negative? Affirmative?

Covenants are restrictions that are written into loan or bond contracts that affect the actions of the
borrower. Negative covenants in effect restrict actions, that is, they are thou shall not... conditions.
Common examples include the nonincrease of dividend payments without permission of the borrower, or
the maintenance of net working capital above some minimum level. Positive covenants encourage actions
such as the submission of quarterly financial statements. In effect both types of covenants are designed
and implemented to assist the lending firm in the monitoring and control of credit risk.

14. Identify and define the borrower-specific and market-specific factors that enter into the credit
decision. What is the impact of each type of factor on the risk premium?

The borrower-specific factors are:

Reputation: Based on the lending history of the borrower; better reputation implies a lower risk
premium.
Leverage: A measure of the existing debt of the borrower; the larger the debt, the higher the risk
premium.
Volatility of earnings: The more stable the earnings, the lower the risk premium.
Collateral: If collateral is offered, the risk premium is lower.

Market-specific factors include:

Business cycle: Lenders are less likely to lend if a recession is forecasted.


Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders
are more reluctant to lend under such conditions.

a. Which of these factors is more likely to affect adversely small businesses rather than large
businesses in the credit assessment process by lenders?

Because reputation involves a history of performance over an extended time period, small
businesses that are fairly young in operating time may suffer.

b. How does the existence of a high debt ratio typically affect the risk of the borrower? Is it
possible that high leverage may reduce the risk of bankruptcy (or the risk of financial distress)?
Explain.

Increasing amounts of debt increase the interest charges that must be paid by the borrower, and thus
decrease the amount of cash flows available to repay the debt principal. Cases have been made that
high debt levels require the firm to be very efficient in its managerial decision making, thus reducing
the probability of bankruptcy.

c. Why is the volatility of the earnings stream of a borrower important to a lender?

A highly volatile earnings stream increases the probability that the borrower cannot meet the fixed
interest and principal payments for any given capital structure.

5
15. Why is the degree of collateral as specified in the loan agreement of importance to the lender? If the
book value of the collateral is greater than or equal to the amount of the loan, is the credit risk of the
lender fully covered? Why, or why not?

Collateral provides the lender with some assets that can be used against the amount of the loan in the case
of default. However, collateral has value only to the extent of its market value, and thus a loan fully
collateralized at book value may not be fully collateralized at market value. Further, errors in the
recording of collateralized positions may limit or severely reduce the protected positions of a lender.

16. Why are FIs consistently interested in the expected level of economic activity in the markets in
which they operate? Why is monetary policy of the Federal Reserve System important to FIs?

During recessions firms in certain industries are much more likely to suffer financial distress because of
the slowdown in economic activity. Specifically, the consumer durables industries are particularly hard
hit because of cutbacks in spending by consumers. Fed monetary actions that increase interest rates cause
FIs to sustain a higher cost of funds and cause borrowers to increase the risk of investments. The higher
cost of funds to the FI can be passed along to the
borrower, but the increased risk in the investment portfolio necessary to generate returns to cover the
higher funding cost to the borrower may lead to increased default risk realization. Thus actions by the
Fed often are signals of future economic activity.

17. What are the purposes of credit scoring models? How could these models possibly assist an FI
manager to better administer credit?

Credit scoring models are used to calculate the probability of default or to sort borrowers into different
default risk classes. The primary benefit is to improve the accuracy of predicting borrowers performance
without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI.

The models use data on observed economic and financial borrower characteristics to assist an FI manager
in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of
importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants,
and (e) more efficiently calculating the necessary reserves to protect against future loan losses.

18. Suppose the estimated linear probability model is PD = 0.3X1 + 0.2X2 - .05X3 + error, where X1 =
0.75 is the borrower's debt/equity ratio; X2 = 0.10 is the volatility of borrower earnings; and X 3 =
0.10 is the borrowers profit ratio.

a. What is the projected probability of default for the borrower?

PD = 0.3(.75) + 0.2(.25) - 0.05(.10) = 0.27

b. What is the projected probability of repayment if the debt/equity ratio is 2.5?

PD = 0.3(2.5) + 0.2(.25) - 0.05(.10) = 0.795


The expected probability of repayment is 1 - 0.795 = 0.205.

c. What is a major weakness of the linear probability model?

A major weakness of this model is that the estimated probabilities can be below 0 or above 1.0, an
occurrence that does not make economic or statistical sense.
6
19. Describe how a linear discriminant analysis model works. Identify and discuss the criticisms that
have been made regarding the use of this type of model to make credit risk evaluations.

Linear discriminant models divide borrowers into high or low default classes contingent on their observed
characteristics. The overall measure of default risk classification (Z) depends on the values of various
financial ratios and the weighted importance of these ratios based on the past or observed experience.
These weights are derived from a discriminant analysis model.

Several criticisms have been levied against these types of models. First, the models identify only two
extreme categories of risk, default or no default. The real world considers several categories of default
severity. Second, The relative weights of the variables may change over time. Further, the actual
variables to be included in the model may change over time. Third, hard to define, but potentially
important, qualitative variables are omitted from the analysis. Fourth, the real-world database of
defaulted loans is very incomplete. Finally, the model is very sensitive to changes in variables. A change
in sales of 40 percent may cause the model to provide different accept/reject decisions, but a decrease in
sales in the real world normally is not seen as hard evidence that credit should be denied or withdrawn
from an otherwise successful company.

20. MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the following
financial information in its application for a loan.

Assets Liabilities and Equity


Cash $ 20 Accounts Payable $ 30
Accounts Receivables $ 90 Notes Payable $ 90
Inventory $ 90 Accruals $ 30
Long Term Debt $150
Plant and equipment $500 Equity $400
Total Assets $700 Total Liabilities & Equity $700

Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40, net
income = $44, the dividend payout ratio is 50 percent, and the market value of equity is equal to the
book value.

a. What is the Altman discriminant function value for MNO, Inc.? Recall that:

Net working capital = Current assets minus current liabilities.


Current assets = Cash + accounts receivable + inventories.
Current liabilities = Accounts payable + accruals + notes payable.
EBIT = Revenues - Cost of goods sold - depreciation.
Taxes = (EBIT - Interest)(tax rate).
Net income = EBIT - interest - taxes.
Retained earnings = Net income (1 - dividend payout ratio)

Altmans discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Assume prior retained earnings are zero.

X1 = (200 -30 -30 -90)/ 700 = .0714 X1 = Working capital/total assets (TA)
X2 = 22 / 700 = .0314 X2 = Retained earnings/TA
7
X3 = 140 / 700 = .20 X3 = EBIT/TA
X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term debt
X5 = 500 / 700 = .7143 X5 = Sales/TA
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104
= .0857 + .044 + .66 + 1.6 + .7143 = 3.104

b. Should you approve MNO, Inc.'s application to your bank for a $500 capital expansion loan?

Since the Z-score of 3.104 is greater than 1.81, ABC Inc.s application for a capital expansion loan
should be approved.

c. If sales for MNO were $300, the market value of equity was only half of book value, and the
cost of goods sold and interest were unchanged, what would be the net income for MNO?
Assume the tax credit can be used to offset other tax liabilities incurred by other divisions of the
firm. Would your credit decision change?

ABCs net income would be -$100 without taking into account text credits. Note, that ABC's tax
liability is -$56,000. If we assume that ABC uses this tax credit against other tax liabilities, then:

X1 = (200 - 30 - 30 - 90) / 700 = .0714


X2 = -44 / 700 = -0.0629
X3 = -60 / 700 = -0.0857
X4 = 200 / 150 = 1.3333
X5 = 300 / 700 = 0.4286

Since ABC's Z-score falls to $.9434 < 1.81, credit should be denied.

d. Would the discriminant function change for firms in different industries? Would the function be
different for retail lending in different geographic sections of the country? What are the
implications for the use of these types of models by FIs?

The discriminant function models are very sensitive to the weights for the different variables. Since
different industries have different operating characteristics, a reasonable answer would be
affirmative with the condition that there is no reason that the functions could not be similar for
different industries. In the retail market, the demographics of the market play a big role in the value
of the weights. For example, credit card companies often evaluate different models for different
areas of the country. Because of the sensitivity of the models, extreme care should be taken in the
process of selecting the correct sample to validate the model for use.

21. Consider the coefficients of Altmans Z-score. Can you tell by the size of the coefficients which
ratio appears most important in assessing the creditworthiness of a loan applicant? Explain.

Although X3, or EBIT/total assets has the highest coefficient (3.3), it is not necessarily the most important
variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be quite small. For
some firms, particularly those in the retail business, the asset turnover ratio, X5 may be quite large and the
product of the X5 coefficient (1.0) and X5 may be substantially larger than the corresponding number for
X3. Generally, the factor that adds most to the Z score varies from firm to firm and industry to industry.

8
22. If the rate of one-year T-Bills currently is 6 percent, what is the repayment probability for each of
the following two securities? Assume that if the loan is defaulted, no payments are expected. What
is the market-determined risk premium for the corresponding probability of default for each
security?

a. One-year AA rated bond yielding 9.5 percent?


Probability of repayment = p = (1 + I)/(1 + k)
For an AA-rated bond = (1 + .06)/ (1 + .095) = 0.968, or 96.8 percent

The market determined risk premium is 0.095 0.060 = 0.035 or 3.5 percent

b. One-year BB rated bond yielding 13.5 percent?

Probability of repayment = p = (1 + I)/(1 + k)


For BB-rated bond = (1 + .06)/(1 + .135) = 93.39 percent

The market determined risk premium is 0.135 0.060 = 0.075 or 7.5 percent

23. A bank has made a loan charging a base lending rate of 10 percent. It expects a probability of
default of 5 percent. If the loan is defaulted, it expects to recover 50 percent of its money through
the sale of its collateral. What is the expected return on this loan?

E(r) = p(1 + k) + (1 - p)(1 + k)() where is the percentage generated when the loan is defaulted. E(r) =
.95(1 + .10) + .05(1 + .10)(.50) = 1.0450 + .0275 = 1.0725 - 1.0 = 7.25%

24. Assume a one-year T-Bill is currently yielding 5.5 percent, and a AAA-rated discount bond with
similar maturity is yielding 8.5 percent.

a. If the expected recovery from collateral in the event of default is 50 percent of principal and
interest, what is the probability of repayment of the AAA-rated bond? What is the probability of
default?

p(1 + k) + (1 - p)(1 + k) = 1+I. Solve for the probability of repayment (p):

1 i
1.055 0.5
1 k
p 1.085 0.9447 or 94.47 percent
1 10.5

Therefore the probability of default is 1.0 - .9447 = 0.0553 or 5.53 percent.

b. What is the probability of repayment of the AAA-rated bond if the expected recovery from
collateral in the case of default is 94.47 percent of principal and interest? What is the probabilit y
of default?

1 i
1.055 0.9447
1 k
p 1.085 0.5000 or 50.00 percent
1 1 0.9447

9
Therefore the probability of default is 1.0 0.5000 = 0.5000 or 50.00 percent.

c. What is the relationship between the probability of default and the proportion of principal and
interest that may be recovered in the case of default on the loan?

The proportion of the loans principal and interest that is collectible on default is a perfect substitute
for the probability of repayment should such defaults occur.

25. What is meant by the phrase marginal default probability? How does this term differ from
cumulative default probability? How are the two terms related?

Marginal default probability is the probability of default in the given time period, whereas cumulative
default probability is the probability of default across several time periods. For example, the cumulative
default probability across two time periods is given below, where (p) is the probability of nondefault in a
given time period.

CP2 = 1 (p1) (p2)

26. Calculate the term structure of default probabilities over three years using the following spot rates
from the Treasury and corporate bond (pure discount) yield curves. Be sure to calculate both the
annual marginal and the cumulative default probabilities.

Spot Spot Spot


1 year 2 year 3 year
Treasury Bonds 5.0% 6.1% 7.0%
BBB rated Bonds 7.0% 8.2% 9.3%

The notation used for implied forward rates is f12 = forward rate from period 1 to period 2.

Treasury Securities BBB Graded Debt


(1.061)2 = (1.05)(1 + f12 ) (1.082)2 = (1.07)(1 + f12 )
f12 = 7.21% f12 = 9.41%

(1.07)3 = (1.061)2(1 + f23 ) (1.093)3 = (1.082)2(1 + f23 )


f23 = 8.82% f23 = 11.53%

Using the implied forward rates, estimate the annual marginal probability of repayment:

p01(1.07) = 1.05 => p1 = 98.13 percent


p12(1.0941) = 1.0721 => p2 = 97.99 percent
p23 (1.1153) = 1.0882 => p3 = 97.57 percent

Using marginal probabilities, estimate the cumulative probability of default:

cp02 = 1 - (p1 )(p 2 )


= 1 - (.9813)(.9799) = 3.84 percent
cp03 = 1 - (p1 )(p 2 )(p3 )
10
= 1 - (.9813)(.9799)(.9757) = 6.18 percent

27. The bond equivalent yields for U.S. Treasury and A-rated corporate bonds with maturities of 93 and
175 days are given below:

Bond Maturities 93 days 175 days


U.S. Treasury 8.07% 8.11%
A-rated corporate 8.42% 8.66%
Spread 0.35% 0.55%

a. What are the implied forward rates for both an 82-day Treasury and an 82-day A-rated bond
beginning in 93 days? Use daily compounding on a 365-day year basis.

. The forward rate, f, for the period 93 days to 175 days, or 82 days, for the Treasury is:

(1 + 0.0811)175/365 = (1 + 0.0807)93/365 (1 + f )82/365 f = 8.16 percent

The forward rate, f, for the corporate bond for the 82-day period is:

(1 + 0.0866)175/365 = (1 + 0.0842) 93/365 (1 + f )82/365 f = 8.933%

b. What is the implied probability of default on A-rated bonds over the next 93 days? Over 175
days?

The probability of repayment of the 93-day A-rated bond is:


p(1 + 0.0842)93/365 = (1 + 0.0807)93/365 p = 99.92 percent
Therefore, the probability of default is (1 - p) = (1 - .9992) = 0.0008 or 0.08 percent.

The probability of repayment of the 175-day A-rated bond is:


p(1 + 0.0866)175/365 = (1 +0.0811)175/365 p = 99.76 percent
Therefore, the probability of default is (1 - p) = (1 - .9976) = 0.0024 or 0.24 percent.

c. What is the implied default probability on an 82-day A-rated bond to be issued in 93 days?

The probability of repayment of the A-rated bond for the period 93 days to 175 days, p, is:
p (1.08933)82/365 = (1 + 0.0816)82/365 p = .9984, or 99.84 percent
Therefore, the probability of default is (1 - p) or 0.0016 or 0.16 percent.

28. What is the mortality rate of a bond or loan? What are some of the problems with using a mortality
rate approach to determine the probability of default of a given bond issue?

Mortality rates reflect the historic default risk experience of a bond or a loan. One major problem is that
the approach looks backward rather than forward in determining probabilities of default. Further, the
estimates are sensitive to the time period of the analysis, the number of bond issues, and the sizes of the
issues.

29. The following is a schedule of historical defaults (yearly and cumulative) experienced by an FI
manager on a portfolio of commercial and mortgage loans.
11
Years after Issuance
Loan Type 1 Year 2 Years 3 Years 4 Years 5 Years
Commercial:
Annual default 0.00% ______ 0.50% ______ 0.30%
Cumulative default ______ 0.10% ______ 0.80% ______
Mortgage:
Annual default 0.10% 0.25% 0.60% ______ 0.80%
Cumulative default ______ ______ ______ 1.64% ______

a. Complete the blank spaces in the table.

Commercial: Annual default 0.00%, 0.10%, 0.50%, 0.20%, and 0.30%


Cumulative default: 0.00%, 0.10%, 0.60%, 0.80%, and 1.10%
Mortgage: Yearly default 0.10%, 0.25%, 0.60%, 0.70%, and 0.80%
Cumulative default 0.10%, 0.35%, 0.95%, 1.64%, and 2.43%

Note: The annual survival rate is pt = 1 annual default rate, and the cumulative default rate for n =
4 of mortgages is 1 (p1* p2* p 3* p4) = 1 (0.999*0.9975*0.9940*0.9930).

b. What are the probabilities that each type of loan will not be in default after 5 years?

The cumulative survival rate is = (1-mmr1)*(1-mmr2)*(1-mmr3)*(1-mmr4)*(1-mmr5) where mmr


= marginal mortality rate

Commercial loan = (1-0.)*(1-0.001)*(1-0.005)*(1-0.002)*(1-0.003) = 0.989 or 98.9%.


Mortgage loan = (1-0.001)*(1-0.0025)*(1-0.006)*(1-0.007)*(1-0.008) = 0.9757 or 97.57%.

c. What is the measured difference between the cumulative default (mortality) rates for commercial
and mortgage loans after four years?

Looking at the table, the cumulative rates of default in year 4 are 0.80% and 1.64%, respectively, for
the commercial and mortgage loans. Another way of estimation is:

Cumulative mortality rate (CMR) = 1- (1 - mmr1)(1 - mmr2)(1 - mmr3)(1 - mmr4)


For commercial loan = 1- (1 - 0.0010)(1 - 0.0010)(1 - 0.0020)(1 - 0.0050)
= 1- .9920 = 0.0080 or 0.80 percent.

For mortgage loan = 1- (1 - 0.0010)(1 - 0.0025)(1 - 0.0060)(1 - 0.0070)


= 1- .98359 = 0.01641 or 1.641 percent.
The difference in cumulative default rates is 1.641 - .80 = .8410 percent.

30. The Table below shows the dollar amounts of outstanding bonds and corresponding default amounts
for every year over the past five years. Note that the default figures are in millions while those
outstanding are in billions. The outstanding figures reflect default amounts and bond redemptions.
Years after Issuance
Loan Type 1 Year 2 Years 3 Years 4 Years 5 Years
A-rated: Annual default (millions) 0 0 0 $1 $2
Outstanding (billions) $100 $95 $93 $91 $88

12
B-rated: Annual default (millions) 0 $1 $2 $3 $4
Outstanding (billions) $100 $94 $92 $89 $85

C-rated: Annual default (millions) $1 $3 $5 $5 $6


Outstanding (billions) $100 $97 $90 $85 $79

a. What are the annual and cumulative default rates of the above bonds?
A-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 0 100,000 0.000000 1.000000 0.000000 0.0000%
2 0 95,000 0.000000 1.000000 0.000000 0.0000%
3 0 93,000 0.000000 1.000000 0.000000 0.0000%
4 1 91,000 0.000011 0.999989 0.000011 0.0011%
5 2 88,000 0.000023 0.999977 0.000034 0.0034%
Where cumulative default for nth year = 1 - product of survival rates to that year.

B-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 0 100,000 0.000000 1.000000 0.000000 0.0000%
2 1 94,000 0.000011 0.999989 0.000011 0.0011%
3 2 92,000 0.000022 0.999978 0.000032 0.0032%
4 3 89,000 0.000034 0.999966 0.000066 0.0066%
5 4 85,000 0.000047 0.999953 0.000113 0.0113%

C-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 1 100,000 0.000010 0.999990 0.000010 0.0010%
2 3 97,000 0.000031 0.999969 0.000041 0.0041%
3 5 90,000 0.000056 0.999944 0.000096 0.0096%
4 5 85,000 0.000059 0.999941 0.000155 0.0155%
5 6 79,000 0.000076 0.999924 0.000231 0.0231%
Years after Issuance
Bond Type 1 Year 2 Years 3 Years 4 Years 5 Years
A-rated: Yearly default 0% 0% 0% 0.0011% 0.0023%
Cumulative default 0% 0% 0% 0.0011% 0.0034%

B-rated: Yearly default 0% 0.0011% 0.0022% 0.0034% 0.0047%


Cumulative default 0% 0.0011% 0.0032% 0.0066% 0.0113%

C-rated: Yearly default 0.0010% 0.0031% 0.0056% 0.0059% 0.0076%


Cumulative default 0.0010% 0.0041% 0.0096% 0.0155% 0.0231%

13
Note: These percentage values seem very small. More reasonable values can be obtained by
increasing the default dollar values by a factor of ten, or by decreasing the outstanding balance
values by a factor of 0.10. Either case will give the same answers that are shown below. While the
percentage numbers seem somewhat more reasonable, the true values of the problem are (a) that
default rates are higher on lower rated assets, and (b) that the cumulative default rate involves more
than the sum of the annual default rates.

C-rated Bonds Test with 10x default.


Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 10 100,000 0.000100 0.999900 0.000100 0.0100%
2 30 97,000 0.000309 0.999691 0.000409 0.0409%
3 50 90,000 0.000556 0.999444 0.000965 0.0965%
4 50 85,000 0.000588 0.999412 0.001552 0.1552%
5 60 79,000 0.000759 0.999241 0.002311 0.2311%
More meaningful to use 0.10x balance, will get same result.

31. What is RAROC? How does this model use the concept of duration to measure the risk exposure of
a loan? How is the expected change in the credit premium measured? What precisely is LN in the
RAROC equation?

RAROC is a measure of expected loan income in the form of interest and fees relative to some measure of
asset risk. The RAROC model uses the duration model formulation to measure the change in the value of
the loan for given changes or shocks in credit quality. The change in credit quality (R) is measured by
finding the change in the spread in yields between Treasury bonds and bonds of the same risk class of the
loan. The actual value chosen is the highest change in yield spread for the same maturity or duration
value assets. In this case, LN represents the change in loan value or the change in capital for the largest
reasonable adverse changes in yield spreads. The actual equation for LN looks very similar to the
duration equation.

Net Income R
RAROC where LN D
LN
x LN x where R is the change in yield spread .
Risk (or LN ) 1 R

32. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge
a servicing fee of 50 basis points. The loan has a maturity of 8 years and a duration of 7.5 years. The
cost of funds (the RAROC benchmark) for the bank is 10 percent. Assume the bank has estimated
the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2
percent, based on two years of historical data. The current market interest rate for loans in this sector
is 12 percent.

a. Using the RAROC model, determine whether the bank should make the loan?

RAROC = Fees and interest earned on loan/ Loan or capital risk

Loan risk, or LN = -DLN *LN*(R/(1 + R) = = -7.5 * $5m * (.042/1.12) = -$1,406,250

14
Expected interest = 0.12 x $5,000,000 = $600,000
Servicing fees = 0.0050 x $5,000,000 = $25,000
Less cost of funds = 0.10 x $5,000,000 = -$500,000
Net interest and fee income = $125,000

RAROC = $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of funds to the
bank, the bank should not make the loan.

b. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:


$125,000/LN = 0.10 LN = 125,000 / 0.10 = $1,250,000
-D LN * LN * (R/(1 + R)) = 1,250,000

DLN = 1,250,000/(5,000,000 * (0.042/1.12)) = 6.67 years.

Thus, this loan can be made if the duration is reduced to 6.67 years from 7.5 years. The duration
can be reduced.

c. Assuming that duration cannot be changed, how much additional interest and fee income would
be necessary to make the loan acceptable?
Necessary RAROC = Income/Risk Income = RAROC * Risk
= $1,406,250 *0.10 = $140,625
Therefore, additional income = $140,625 - $125,000 = $15,625.

d. Given the proposed income stream and the negotiated duration, what adjustment in the risk
premium would be necessary to make the loan acceptable?

$125,000/0.10 = $1,250,000 -$1,250,000 = -7.5*$5,000,000*(R/1.12)


Thus R = 1.12(-$1,250,000)/(-7.5*$5,000,000) = 0.0373

33. A firm is issuing a two-year debt in the amount of $200,000. The current market value of the assets
is $300,000. The risk-free rate is 6 percent, and the standard deviation of the rate of change in the
underlying assets of the borrower is 10 percent. Using an options framework, determine the
following:

a. The current market value of the loan.


b. The risk premium to be charged on the loan.

The following need to be estimated first: d, h1 and h2 .

d = Be-rt /A = $200,000e-.06(2) /300,000 = .5913 or 59.13 percent.


h1 = -[0.5*(.10)2 *2 - ln(.5913)]/(.10)21/2 = -3.7863
h2 = -[0.5*(.10)2 *2 + ln(.5913)]/(.10)2 1/2 = 3.6449

Current market value of loan = l(t) = Be-rt [N(h1)1/d + N(h2)]


= $177,384.09[1.6912 * N(-3.7863) + N(3.6449)]
15
= $177,384.09[1.6912 * 0.0001 + 0.9999] = $177,396.35

The risk premium k I = (-1/t) ln[N(h2) + (1/d)N(h1)]


= (-)ln[0.9999 + 1.6912*0.0001] = 0.00035

34. A firm has assets of $200,000 and total debts of $175,000. Using an option pricing model, the
implied volatility of the firms assets is estimated at $10,730. Under the KMV method, what is the
expected default frequency (assuming a normal distribution for assets)?

The firm will be in technical bankruptcy if the value of the assets falls below $175,000. If = $10,730,
then it takes 25,000/10,730 = 2.33 standard deviations for the assets to fall below this value. Under the
assumption that the market value of the assets are normally distributed, then 2.33 represents a 1 percent
probability that the firm will become bankrupt.

35. Carman County Bank (CCB) has outstanding a $5,000,000 face value, adjustable rate loan to a
company that has a leverage ratio of 80 percent. The current risk free rate is 6 percent, and the time
to maturity on the loan is exactly year. The asset risk of the borrower, as measured by the
standard deviation of the rate of change in the value of the underlying assets, is 12 percent. The
normal density function values are given below:

h N(h) h N(h)
-2.55 0.0054 2.50 0.9938
-2.60 0.0047 2.55 0.9946
-2.65 0.0040 2.60 0.9953
-2.70 0.0035 2.65 0.9960
-2.75 0.0030 2.70 0.9965

a. Use the Merton option valuation model to determine the market value of the loan.

The following need to be estimated first: d, h1 and h2 .


h1 = -[0.5*(0.12)2*0.5 - ln(0.8)]/(0.12)0.5 = -0.226744/0.084853 = -2.672198
h2 = -[0.5*(0.12)2*0.5 + ln(0.8)]/(0.12)0.5 = 0.219544/0.084853 = 2.587346

Current market value of loan = l(t) = Be-rt [N(h1)1/d + N(h2)]


= $4,852,227.67[1.25*N(-2.672198) + N(2.587346)]
= $4,852,227.67 [1.25*0.003778 + 0.995123]
= $4,851,478.00

b. What should be the interest rate for the last six months of the loan?

The risk premium k I = (-1/t) ln[N(h2) + (1/d)N(h1)]


= (-1/0.5)ln[0.995123 + 1.25*0.003778] = 0.000308

The loan rate = risk-free rate plus risk premium = 0.06 + 0.000308 = 0.060308 or 6.0308%.

The questions and problems that follow refer to Appendixes 11A and 11B. Refer to the example
information in Appendix 11A.
16
36. From Table 11A-1, what is the probability of a loan upgrade? A loan downgrade?

The probability of an upgrade is 5.95% + 0.33% + 0.02% = 6.30%. The probability of a downgrade is
5.30% + 1.17% + 0.12% = 5.59%.

a. What is the impact of a rating upgrade or downgrade?

The effect of a rating upgrade or downgrade will be reflected on the credit-risk spreads or premiums
on loans, and thus on the implied market value of the loan. A downgrade should cause this credit
spread premium to rise.

b. How is the discount rate determined after a credit event has occurred?

The discount rate for each year in the future in which cash flows are expected to be received
includes the forward rates from the current Treasury yield curve plus the annual credit spreads for
loans of a particular rating class for each year. These credit spreads are determined by observing the
spreads of the corporate bond market over Treasury securities.

c. Why does the probability distribution of possible loan values have a negative skew?

The negative skew occurs because the probability distribution is non-normal. The potential
downside change in a loans value is greater than the possible upside change in value.

d. How do the capital requirements of the CreditMetrics approach differ from those of the BIS and
Federal Reserve System?

The Fed and the BIS require the capital reserve to be 8 percent of the book value of the loan. Under
CreditMetrics each loan is likely to have a different VAR and thus a different implied capital
requirement. Further, this required capital is likely to be greater than 8 percent of book value
because of the non-normality of the probability distributions.

37. A five-year fixed-rate loan of $100 million carries a 7 percent annual interest rate. The borrower is
rated BB. Based on hypothetical historical data, the probability distribution given below has been
determined for various ratings upgrades, downgrades, status quo, and default possibilities over the
next year. Information also is presented reflecting the forward rates of the current Treasury yield
curve and the annual credit spreads of the various maturities of BBB bonds over Treasuries.
New Loan
Probability Value plus Forward Rate Spreads at time t
Rating Distribution Coupon $ t rt% st%
AAA 0.01% $114.82 1 3.00% 0.72%
AA 0.31% $114.60 2 3.40% 0.96%
A 1.45% $114.03 3 3.75% 1.16%
BBB 6.05% 4 4.00% 1.30%
BB 85.48% $108.55
B 5.60% $98.43
CCC 0.90% $86.82
Default 0.20% $54.12

17
a. What is the present value of the loan at the end of the one-year risk horizon for the case where
the borrower has been upgraded from BB to BBB?

$7 $7 $7 $107
PV $7 $113 .27 million
1.0372 (1.0436) (1.0491) (1.0530) 4
2 3

b. What is the mean (expected) value of the loan at the end of year one?

The solution table on the following page reveals a value of $108.06.

c. What is the volatility of the loan value at the end of the year?

The volatility or standard deviation of the loan value is $4.19.

d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal distribution of
values.

The 5 percent VAR is 1.65 x $4.19 = $6.91.


The 1 percent VAR is 2.33 x $4.19 = $9.76.

Probability
Year-end Probability * Deviation
Rating Probability Value * Value Deviation Squared
AAA 0.0001 $114.82 $0.01 6.76 0.0046
AA 0.0031 $114.60 $0.36 6.54 0.1325
A 0.0145 $114.03 $1.65 5.97 0.5162
BBB 0.0605 $113.27 $6.85 5.21 1.6402
BB 0.8548 $108.55 $92.79 0.49 0.2025
B 0.056 $98.43 $5.51 -9.63 5.1968
CCC 0.009 $86.82 $0.78 -21.24 4.0615
Default 0.002 $54.12 $0.11 -53.94 5.8197
1.000 Mean = $108.06 Variance = 17.5740
Standard Deviation = $4.19

e. Estimate the approximate 5 percent and 1 percent VARs using the actual distribution of loan
values and probabilities.

5% VAR = 95% of actual distribution = $108.06 - $102.02 = $6.04


1% VAR = 99% of actual distribution = $108.06 - $86.82 = $21.24

where: 5% VAR is approximated by 0.056 + 0.009 + 0.002 = 0.067 or 6.7 percent, and
1% VAR is approximated by 0.009 + 0.002 = 0.011 or 1.1 percent.

Using linear interpolation, the 5% VAR = $10.65 million and the 1% VAR = $19.31 million. For
the 1% VAR, $19.31 = (1 0.1/1.1)*$21.24.

f. How do the capital requirements of the 1 percent VARs calculated in parts (d) and (e) above
compare with the capital requirements of the BIS and Federal Reserve System?

18
The Fed and BIS systems would require 8 percent of the loan value, or $8 million. The 1 percent
VAR would require $19.31 million under the approximate method, and $9.76 million in capital
under the normal distribution assumption. In each case, the amounts exceed the Fed/BIS amount.

g. Go to the J.P. Morgan Chase website (www.jpmorgan.com/RiskManagement/CreditMetrics).


What data set information is provided for use with CreditMetrics?

38. How does the Credit Risk+ model of Credit Suisse Financial Products differ from the CreditMetrics
model of J.P. Morgan?

Credit Risk attempts to estimate the expected loss of loans and the distribution of these losses with the
focus on calculating the required capital reserves necessary to meet these losses. The method assumes
that the probability of any individual loan defaulting is random, and that the correlation between the
defaults on any pair of loan defaults is zero. CreditMetrics is focussed on estimating a complete VAR
framework.

39. An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have an historical default rate
of 4 percent, and the severity of loss is 40 cents per $1. Note: This question refers to material in
Appendix 11B.

a. Over the next year, what are the probabilities of having default rates of 2, 3, 4, 5, and 8 percent?

e m m n ( 2.71828) 4 x 4 2 0.018316 x16


Pr obability of 2 defaults 0.1465
n! 1x 2 2

n 2 3 4 5 8
Probability 0.1465 0.1954 0.1954 0.1563 0.0298

b. What would be the dollar loss on the portfolios with default rates of 4 and 8 percent?

Dollar loss of 4 loans defaulting = 4 x 0.40 x $10,000 = $16,000


Dollar loss of 8 loans defaulting = 8 x 0.40 x $10,000 = $32,000

c. How much capital would need to be reserved to meet the 1 percent worst-case loss scenario?
What proportion of the portfolios value would this capital reserve be?

The probability of 8 defaults is ~3 percent. The probability of 10 defaults is 0.0106 or close to 1


percent. The dollar loss of 10 loans defaulting is $40,000. Thus a 1 percent chance of losing
$40,000 exists.

A capital reserve should be held to meet the difference between the unexpected 1 percent loss rate
and the expected loss rate of 4 defaults. This difference is $40,000 minus $16,000 or $24,000. This
amount is 0.024 percent of the total portfolio.

19
Chapter Twelve
Credit Risk: Loan Portfolio and Concentration Risk
Chapter Outline

Introduction

Simple Models of Loan Concentration

Loan Portfolio Diversification and Modern Portfolio Theory (MPT)


KMV Portfolio Manager
Partial Applications of Portfolio Theory
Loan Loss Ratio-Based Models
Regulatory Models

Summary

Solutions for End-of-Chapter Questions and Problems: Chapter Twelve

1. How do loan portfolio risks differ from individual loan risks?

Loan portfolio risks refer to the risks of a portfolio of loans as opposed to the risks of a single loan. Inherent
in the distinction is the elimination of some of the risks of individual loans because of benefits from
diversification.

2. What is migration analysis? How do FIs use it to measure credit risk concentration? What are its
shortcomings?

Migration analysis uses information from the market to determine the credit risk of an individual loan or
sectoral loans. For example, bankers can use S&P and Moodys ratings to determine whether firms in a
particular sector are experiencing repayment problems. This information can be used to either curtail lending
in that sector or to reduce maturity and/or increase interest rates. A problem with migration analysis is that
the information may be too late, because ratings agencies usually downgrade issues only after the firm or
industry has experienced a downturn.

3. What does loan concentration risk mean?

Loan concentration risk refers to the extra risk borne by having too many loans concentrated with one firm,
industry, or economic sector. To the extent that a portfolio of loans represents loans made to a diverse cross
section of the economy, concentration risk is minimized.

4. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of
equity.

a. If the average historical losses in the automobile sector total 8 percent, what is the maximum loan a
manager can lend to a firm in this sector as a percentage of total capital?

Maximum limit = (Maximum loss as a percent of capital) x (1/Loss rate) = .05 x 1/0.08
= 62.5 percent is the maximum limit that can be lent to a firm in the

1
automobile sector.

b. If the average historical losses in the mining sector total 15 percent, what is the maximum loan a
manager can lend to a firm in this sector as a percentage of total capital?

Maximum limit = (Maximum loss as a percent of capital) x (1/Loss rate) = .05 x 1/0.15
= 33.3 percent is the maximum limit that can be lent to a firm in the
mining sector.

5. An FI has set a maximum loss of 12 percent of total capital as a basis for setting concentration limits on
loans to individual firms. If it has set a concentration limit of 25 percent to a firm, what is the expected
loss rate for that firm?

Maximum limit = (Maximum loss as a percent of capital) x (1/Loss rate)


25 percent = 12 percent x 1/Loss rate Loss rate = 0.12/0.25 = 48 percent

6. Explain how modern portfolio theory can be applied to lower the credit risk of an FIs portfolio.

Modern portfolio theory has demonstrated that a well-diversified portfolio can provide opportunities for
individuals to invest in a set of efficient frontier portfolios, defined as those portfolios that provide the
maximum returns for a given level of risk or the lowest risk for a given level of returns. By choosing
portfolios on the efficient frontier, a banker may be able to reduce credit risk to the fullest extent. As shown
in Figure 11.1, a managers selection of a particular portfolio on the efficient frontier is determined by his or
her risk-return trade-off.

7. The Bank of Tinytown has two $20,000 loans that have the following characteristics: Loan A has an
expected return of 10 percent and a standard deviation of returns of 10 percent. The expected return
and standard deviation of returns for loan B are 12 percent and 20 percent, respectively.

a. If the covariance between A and B is .015 (1.5 percent), what are the expected return and standard
deviation of this portfolio?

Expected return = 0.5(10%) + 0.5(12%) = 11 percent


Standard deviation = [0.52(0.102) + 0.52(0.202) + 2(0.5)(0.5)(0.015)] = 14.14 percent

b. What is the standard deviation of the portfolio if the covariance is -.015 (-1.5 percent)?
2 2 2 2
Standard deviation = [0.5 (0.10 ) + 0.5 (0.20 ) + 2(0.5)(0.5)(-0.015)] = 7.07 percent

c. What role does the covariance, or correlation, play in the risk reduction attributes of modern
portfolio theory?

The risk of the portfolio as measured by the standard deviation is reduced when the covariance is
reduced. If the correlation is less than +1.0, the standard deviation of the portfolio always will be less
than the weighted average standard deviations of the individual assets.

8. Why is it difficult for small banks and thrifts to measure credit risk using modern portfolio theory?
2
The basic premise behind modern portfolio theory is the ability to diversify and reduce risk by eliminating
diversifiable risk. Small banks and thrifts may not have the ability to diversify their asset base, especially if
the local markets in which they serve have a limited number of industries. The ability to diversify is even
more acute if these loans cannot be traded easily.

9. What is the minimum risk portfolio? Why is this portfolio usually not the portfolio chosen by FIs to
optimize the return-risk tradeoff?

The minimum risk portfolio is the combination of assets that reduces the portfolio risk as measured by the
standard deviation or variance of returns to the lowest possible level. This portfolio usually is not the
optimal portfolio choice because the returns on this portfolio are very low relative to other alternative
portfolio selections. By accepting some additional risk, portfolio managers are able to realize a higher level
of return relative to the risk of the portfolio.

10. The obvious benefit to holding a diversified portfolio of loans is to spread risk exposures so that a
single event does not result in a great loss to the bank. Are there any benefits to not being diversified?

One benefit to not being diversified is that a bank that lends to a certain industrial or geographic sector is
likely to gain expertise about that sector. Being diversified requires that the bank becomes familiar with
many more areas of business. This may not always be possible, particularly for small banks.

11. A bank vice president is attempting to rank, in terms of the risk-reward trade-off, the loan portfolios of
three loan officers. How would you rank the three portfolios? Information on the portfolios is noted
below.

Expected Standard
Portfolio Return Deviation
A 10% 8%
B 12% 9%
C 11% 10%

Portfolio B dominates portfolio C because B has a higher expected return and a lower standard deviation.
Thus C is clearly inferior. A comparison of portfolios A and B represents a risk-return trade-off in that B has
a higher expected return, but B also has a higher risk measure. A crude comparison may use the coefficient
of variation or the Sharpe measure, but a judgement regarding which portfolio is better would be based on
the risk preference of the judge.

12. CountrySide Bank uses the KMV Portfolio Manager model to evaluate the risk-return characteristics of
the loans in its portfolio. A specific $10 million loan earns 2 percent per year in fees, and the loan is
priced at a 4 percent spread over the cost of funds for the bank. Because of collateral considerations,
the loss to the bank if the borrower defaults will be 20 percent of the loans face value. The expected
probability of default is 3 percent. What is the anticipated return on this loan? What is the risk of the
loan?

Expected return = AISi E(Li) = (0.02 + 0.04) (0.03 x 0.20) = .054 or 5.4 percent
Risk of the loan = Di x LGDi = [0.03(0.97)] x 0.20 = 0.0341 or 3.41 percent

13. What databases are available that contain loan information at national and regional levels? How can
they be used to analyze credit concentration risk?

3
Two publicly available databases are (a) the Commercial bank call reports of the Federal Reserve Board
which contain various information supplied by banks quarterly, and (b) the shared national credit database,
which provides information on loan volumes of FIs separated by two-digit SIC (Standard Industrial
Classification) codes. Such data can be used as a benchmark to determine whether a banks asset allocation
is significantly different from the national or regional average.

14. Information concerning the allocation of loan portfolios to different market sectors is given below:
Allocation of Loan Portfolios in Different Sectors (%)
Sectors National Bank A Bank B
Commercial 30% 50% 10%
Consumer 40% 30% 40%
Real Estate 30% 20% 50%

Bank A and Bank B would like to estimate how much their portfolios deviate from the national
average.

a. Which bank is further away from the national average?

Using Xs to represent portfolio holdings:


Bank A Bank B
(X1j - X1 ) 2 (.50 - .30)2 = 0.04 (.10 - .30) 2 = 0.04
(X2j - X2 )2 (.30 - .40)2 = 0.01 (.40 - .40) 2 = 0.00
(X3j - X3 )2 (.20 - .30)2 = 0.01 (.50 - .30) 2 = 0.04
n n 3 n 3


i
1
( X ij X i ) 2 0.06
i
1
0.08
i
1
n

( X ij X i )
2

i
1
= 0.1414 or 14.14 percent = 0.1633 or 16.33 percent
n
Bank B deviates from the national average more than Bank A.

b. Is a large standard deviation necessarily bad for a bank using this model?

No, a higher standard deviation is not necessarily bad for an FI because it could have comparative
advantages that are not required or available to a national well-diversified bank. For example, a bank
could generate high returns by serving specialized markets or product niches that are not well
diversified. Or, a bank could specialize in only one product, such as mortgages, but be well-diversified
within this product line by investing in several different types of mortgages that are distributed both
nationally and internationally. This would still enable it to obtain portfolio diversification benefits that
are similar to the national average.
15. Assume that the averages for national banks engaged primarily in mortgage lending have their assets
diversified in the following proportions: 20 percent residential, 30 percent commercial, 20 percent
international, and 30 percent mortgage-backed securities. A local bank has the following ratios: 30
percent residential, 40 percent commercial, and 30 percent international. How does the local bank
differ from the national banks?

Using Xs to represent portfolio holdings:


(X1j - X1 )2 (.30 - .20)2 = 0.01
4
(X2j - X2 )2 (.40 - .30)2 = 0.01
(X3j - X3 )2 (.30 - .20)2 = 0.01
(X4j - X4 )2 (.0 - .30)2 = 0.09
n n 4

( X ij X i ) 2
i
1
0.12
i
1
n

( X ij X i ) 2
i
1
= 0.1732 or 17.32 percent
n

The banks standard deviation is 17.32 percent, suggesting that it is different from the national average.
Whether it is significantly different cannot be stated without comparing it to another bank.

16. Using regression analysis on historical loan losses, a bank has estimated the following:

XC = 0.002 + 0.8XL, and Xh = 0.003 + 1.8XL

where XC = loss rate in the commercial sector, Xh = loss rate in the consumer (household) sector, XL
= loss rate for its total loan portfolio.

a. If the banks total loan loss rates increase by 10 percent, what are the increases in the expected loss
rates in the commercial and consumer sectors?

Commercial loan loss rates will increase by 0.002 + 0.8(0.10) = 8.20 percent.
Consumer loan loss rates will increase by 0.003 + 1.8(0.10) = 18.30 percent.

b. In which sector should the bank limit its loans and why?

The bank should limit its loans to the consumer sector because the loss rates are systematically higher
than the loss rates for the total loan portfolio. Loss rates are lower for the commercial sector. For a 10
percent increase in the total loan portfolio, the consumer loss rate is expected to increase by 18.30
percent, as opposed to only 8.2 percent for the commercial sector.

17. What reasons did the Federal Reserve Board offer for recommending the use of subjective evaluations
of credit concentration risk instead of quantitative models?

The Federal Reserve Board recommended a subjective evaluation of credit concentration risk instead of
quantitative models because (a) current methods to identify credit concentrations are not reliable, and (b)
there is insufficient data to develop reliable quantitative models.

18. What rules on credit concentrations have the National Association of Insurance Commissioners
proposed? How are they related to modern portfolio theory?

The NAIC has set a maximum limit of 3% that life and health insurers can hold in securities belonging to a
single issuer. Similarly, the limit is 5% for property-casualty (P/C) insurers. This forces life insurers to hold
a minimum of 34 different securities and P/C insurers to hold a minimum of 20 different securities. Modern
portfolio theory shows that by holding well-diversified portfolios, investors can eliminate undiversifiable risk
5
and be subject only to market risk. This enables investors to hold portfolios that provide either high returns
for a given level of risk or low risks for a given level of returns.

19. An FI is limited to holding no more than 8 percent of securities of a single issuer. What is the minimum
number of securities it should hold to meet this requirement? What if the requirements are 2 percent, 4
percent, and 7 percent?

If an FI is limited to holding a maximum of 8 percent of securities of a single issuer, it will be forced to hold
100/8 = 12.5, or 13 different securities.
For 2%, it will be 100/2, or 50 different securities.
For 4%, it will be 100/4, or 25 different securities.
For 7%, it will be 100/7, or 15 different securities.

6
Additional Example for Chapter 12

Allocation of Loan Portfolios in Different Sectors (%)


Sectors National Bank A Bank B

Commercial 20% 50% 30%


Consumer 40% 20% 40%
Real Estate 40% 30% 30%

How different are Banks A and B from the national benchmark? When using this example, note that there is
an implied assumption that Bank A and B belong to a certain size class or have some common denominator
linking them to the national benchmark. If that is the case, then the solution is to estimate the standard
deviation.

We use Xs to represent the portfolio concentrations. X1, X2 and X3 are the national benchmark percentages
Bank A Bank B
(X 1j - X1 ) 2 2
(.50 - .20) = 0.09 (.30 - .20) 2 = 0.01
(X 2j - X2 )2 (.20 - .40)2 = 0.04 (.40 - .40) 2 = 0.00
(X 3j - X3 )2 (.30 - .40)2 = 0.01 (.30 - .40) 2 = 0.01
n n 3 n 3

(X ij X i ) 2 0.14 0.02
i
1 i
1 i
1
n

( X ij X i ) 2
i
1
= 0.3742 or 37.42 percent = 0.1414 or 14.14 percent
n

Thus we can see here that Bank A is significantly different from the national benchmark

Md. Monjur Morshed


th
MBA 7 Batch
Dept. of Finance
University of Dhaka

7
Chapter Thirteen
Off-Balance-Sheet Activities

Chapter Outline

Introduction

Off-Balance-Sheet Activities and FI Solvency

Returns and Risks of Off-Balance-Sheet Activities


Loan Commitments
Commercial Letters of Credit and Standby Letters of Credit
Derivative Contracts: Futures, Forwards, Swaps, and Options
Forward Purchases and Sales of When Issued Securities
Loans Sold

Nonschedule L Off-Balance-Sheet Risks


Settlement Risk
Affiliate Risk

The Role of OBS Activities in Reducing Risk

Summary

Solutions for End-of-Chapter Questions and Problems: Chapter Thirteen

1. Classify the following items as either (1) on-balance-sheet assets, (2) on-balance-sheet liabilities, (3)
off-balance-sheet assets, (4) off-balance-sheet liabilities, or (5) capital account.
Classification
a. Loan commitments 3
b. Loan loss reserves 5
c. Letter of credit 2
d. Bankers acceptance 2
e. Rediscounted bankers acceptance 2
f. Loan sales without recourse None of the above.
g. Loan sales with recourse 3
h. Forward contracts to purchase 3
I. Forward contracts to sell 4
j. Swaps 4 (for liability swaps)
k. Loan participations 1
l. Securities borrowed 3
m. Securities lent 4
n. Loss adjustment expense account (PC insurers) 2
o. Net policy reserves 2
2. How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability?

Off-balance-sheet activities or items are contingent claim contracts. An item is classified as an off-balance-
sheet asset when the occurrence of the contingent event results in the creation of an on-balance-sheet asset.
1
An example is a loan commitment. If the borrower decides to exercise the right to draw down on the loan,
the bank will incur a new asset on its portfolio. Similarly, an item is an off-balance-sheet liability when the
contingent event creates an on-balance-sheet liability. An example is a standby letter of credit (LC). In the
event that the original payer of the LC defaults, then the bank is liable to pay the amount to the payee,
incurring a liability on the right-hand side of its balance sheet.

3. Contingent Bank has the following balance sheet in market value terms (in millions of dollars):

Assets Liabilities
Cash $20 Deposits $220
Mortgages $220 Equity $20
Total Assets $240 Total Liabilities & Equity $240

In addition, the bank has contingent assets with $100 million market value and contingent liabilities
with $80 million market value. What is the true stockholder net worth? What does the term contingent
mean?
Net worth = (240-220) + (100-80) = $40 million. The term contingent means an event that may or may not
happen. In financial economics, the term is used in conjunction with the result given that some event does
occur.

4. How are contingent assets and liabilities like options? What is meant by the delta of an option? What
is meant by the term notional value?

Contingent assets and liabilities may or may not become on-balance-sheet assets and liabilities in a manner
similar to the exercise or non-exercise of an option. In each case the realization of the event is contingent or
dependent on the occurrence of some other event. The delta of an option is the sensitivity of an options
value for a unit change in the price of the underlying security. The notional value represents the amount of
value that will be placed in play if the contingent event occurs. The notional value of a contingent asset or
liability is the amount of asset or liability that will appear on the balance sheet is the contingent event occurs.

5. An FI has purchased options on bonds with a notional value of $500 million and has sold options on
bonds with a notional value of $400 million. The purchased options have a delta of 0.25, and the sold
options have a delta of 0.30. What is (a) the contingent asset value of this position, (b) the contingent
liability value of this position, and (c) the contingent market value of net worth?

a. The contingent asset value is $500 million x 0.25 = $125 million.

b. The contingent liability value is $400 million x 0.30 = $130 million.

c. The contingent market value of net worth is $125 million - $130 million = -$5 million.

6. What factors explain the growth of off-balance-sheet activities in the 1980s and 1990s among U.S. FIs?

The narrowing of spreads on on-balance-sheet lending in a highly competitive market and large loan losses
by commercial banks gave impetus to seek other sources of income in the 1980s. Off-balance-sheet
activities represented one avenue. In addition, off-balance-sheet assets and liabilities were not subject to
capital requirements or reserve requirements, increasing the effective returns on these activities.

2
7. What role does Schedule L play in reporting off-balance-sheet activities? Refer to Table 13-5. What
was the annual growth rate over the 11-year period 1992-2003 in the notional value of off-balance-
sheet items compared with on-balance-sheet items? Which contingencies have exhibited the most
rapid growth?

Schedule L is a method for the Federal Reserve to track the types and amounts of off-balance-sheet (OBS)
activities of commercial banks. Most of the OBS mentioned in this chapter are reported in Schedule L on the
quarterly call reports, although items associated with settlement risk and affiliate risk are not reported.
The following information from Table 13-5 reflects the most significant OBS items in terms of notional
value:
Annual Growth
OBS Item Rate (%)
Commitments to lend 14.3%
Future and forward contracts on interest rates 13.3%
Written option contracts on interest rates 25.2%
Purchased option contracts on interest rates 25.1%
Commitments to buy foreign exchange 5.0%
Notional value of all outstanding interest rate swaps 31.0%
Total OBS 19.9%

Total assets (on-balance-sheet items) 7.2%

Clearly the off balance sheet items have grown at a much faster rate than the on-balance-sheet items for U.S.
commercial banks. Further, the dollar value of the notional OBS items was a multiple of 10.1 times as large
as the dollar value of the on-balance-sheet items at the end of 2003.

8. What are the characteristics of a loan commitment that an FI may make to a customer? In what manner
and to whom is the commitment an option? What are the various possible pieces of the option
premium? When does the option or commitment become an on-balance-sheet item for the bank and the
borrower?

A loan commitment is an agreement to lend a fixed maximum amount of money to a firm within some given
amount of time. The interest rate or rate spread normally is determined at the time of the agreement, as is the
length of time that the commitment is open. Because the firm usually triggers the timing of the draw, which
may be any portion of the total commitment, the commitment is an option to the borrower. If the loan is not
needed, the option or draw will not be exercised. The premium for the commitment may include a fee of
some percent times the total commitment and a fee of some percent times the amount of the unused
commitment. Of course the borrower must pay interest while any portion of the commitment is in use. The
option becomes an on-balance-sheet item for both parties at the point in time that a draw occurs.

9. A FI makes a loan commitment of $2,500,000 with an up-front fee of 50 basis points and a back-end
fee of 25 basis points on the unused portion of the loan. The take-down on the loan is 50 percent.

a. What total fees does the FI earn when the loan commitment is negotiated?

Up-front fee = $2,500,000 x 0.0050 = $12,500

b. What are the total fees earned by the FI at the end of the year, that is, in future value terms?
Assume the cost of capital for the bank is 6 percent.
3
4
Up-front fee = $2,500,000 x 0.0050 (1.06) = $13,250
Back-end fee = $2,500,000 x 0.0025 x 0.50 = 3,125
Total = $16,375

10. A FI has issued a one-year loan commitment of $2,000,000 for an up-front fee of 25 basis
points. The back-end fee on the unused portion of the commitment is 10 basis points. The
FI requires a compensating balance of 5 percent as demand deposits. The FIs cost of
funds is 6 percent, the interest rate on the loan is 10 percent, and reserve requirements on
demand deposits are 8 percent. The customer is expected to draw down 80 percent of the
commitment at the beginning of the year.

a. What is the expected return on the loan without taking future values into consideration?

Up-front fees = 0.0025 x $2,000,000 = $ 5,000


Interest income = 0.10 x $1,600,000 = 160,000
Back-end fee = 0.0010 x $400,000 = 400
Total = $165,400

Funds committed = $1,600,000 - $80,000 (compensating balances) + $6,400 (Reserve


requirements on demand deposits) = $1,526,400.

Expected rate of return = $165,400/$1,526,400 = 10.836%

f 1 + f 2 (1 - td) + (BR + m)td


Using the formula: 1 + k = 1 +
td - b (td ) (1 - RR)

1 + k = 1 + [(0.0025) + (0.0010)(1 - 0.80) + (0.10)*0.80]/{0.80 - [0.05(0.80)(1 - 0.08) ]}


1 + k = 1.1082, or k = 10.836 percent.

b. What is the expected return using future values? That is, the net fee and interest
income is evaluated at the end of the year when the loan is due?

The only difference is that the up-front fee is estimated at year-end, i.e., $5,000 x 1.06 =
$5,300. Thus, expected return = $165,700/$1,526,400 = 10.8556%.

Using the formula:


1+k = 1 + [(0.0025(1+0.06) + 0.0010(1-0.80) + (0.10)*0.80]/{0.80-[0.05(0.80)(1-0.08)]}
1+k = 1.1084, or k = 10.8556 percent.

c. How is the expected return in part (b) affected if the reserve requirements on demand
deposits are zero?

In this case, the amount of funds committed is reduced by the amount normally set for
reserves, i.e., $6,400. Thus, expected return = $165,700/$1,520,000 = 10.90%.
Using the formula:

5
1 + k = 1 + [(0.0025(1 + .06) + 0.0010(1 - 0.80) + (0.10) * 0.80]/ {0.80 - [0.05(0.80)]}
1 + k = 1.1090, or k = 10.90 percent.

d. How is the expected return in part (b) affected if compensating balances are paid a
nominal interest rate of 5 percent?

Here, we need to subtract additional payments of interest on reserve requirements from the
total fees and interest earned, i.e., 0.05 x $80,000 = $4,000.

Expected return = $161,700/1,526,400 = 10.5936%


Using the formula:
1+k = 1+[(.0025(1+.06)+.0010(1-.80)+0.10(.80)-.05(.05)(.80)]/[.80-.05(.80)(1-.08)]
1 + k = 1.1058, or k = 10.5936 percent.

e. What is the expected return using future values but with the funding of demand
deposits replaced by certificates of deposit that have an interest rate of 5.5 percent and
no reserve requirements?

In this case we assume that no compensating balance is required and that the entire loan
draw is funded with CDs. Thus revenue in part (c) above is reduced by $1,600,000 x 0.055
= $88,000, and the expected return is $77,700/$1,600,000 = 4.8563 percent.

Using the formula:


1 + k = 1 + [(0.0025(1+0.06) + 0.0010(1-0.80) + (0.10-0.055) * 0.80]/[0.80]
1 + k = 1.048563, or k = 4.86 percent.

11. Suburb Bank has issued a one-year loan commitment of $10,000,000 for an up-front fee of
50 basis points. The back-end fee on the unused portion of the commitment is 20 basis
points. The bank requires a compensating balance of 10 percent on demand deposits, has a
cost of funds of 7 percent, will charge an interest rate on the loan of 9 percent, and must
maintain reserve requirements on demand deposits of 10 percent. The customer is
expected to draw down 60 percent of the commitment.

a. What is the expected return on this loan?

Up-front fee = 0.0050 x $10,000,000 = $50,000


Interest income = 0.0900 x $6,000,000 = $540,000
Back-end fee = 0.0020 x $4,000,000 = $8,000
Total revenue $598,000

Funds committed = $6,000,000 - $600,000 (compensating balance) + $60,000 (reserve


requirements on demand deposits) = $5,460,000.

Expected rate of return = $598,000/$5,460,000 = 10.95 percent.

6
f 1 + f 2 (1 - td) + (BR + m)td


Using the formula: 1 + k = 1 +
td - b (td ) (1 - RR)

1 + k = 1 + [(0.0050) + (0.0020)(1 - 0.60) + (0.09)*0.60]/{0.60 - [0.10(0.60)(1 - 0.10)]}


1 + k = 1.1095, or k = 10.95 percent.

Note that adjustment has not been made for the fact that the up-front fee is usually
collected at the beginning of the period. To adjust, a common treatment is to find the
future value for this fee by multiplying by banks cost of capital. Thus, $50,000x(1+0.07)
= $53,500, and the expected return is 11.02 percent. Using the formula, multiplying f1 by
(1.07) will provide the same answer.

b. What is the expected return per annum on the loan if the draw-down on the
commitment does not occur until at the end of 6 months?

In this case the fees remain the same, but the interest revenue will be only half as large, and
the average balance outstanding will be only half as large. Thus revenue will be $598,000 -
$270,000 = $328,000, and the funds committed will be $5,460,000/2 = $2,730,000. The
expected rate of return on an annual basis is 12.0147 percent. Note the return is greater
than the return calculated in part (a) because the fees are dollar sensitive, not time sensitive.

12. How is an FI exposed to interest rate risk when it makes loan commitments? In what way
can an FI control for this risk? How does basis risk affect the implementation of the
control for interest rate risk?

When a bank makes a fixed-rate loan commitment, it faces the likelihood that interest rates may
increase during the intervening period. This reduces its net interest income if the borrower
decides to take down the loan. The bank can partially offset this loan by making variable rate
loan commitments. However, this still does not protect it against basis risk, that is, if lending
rates and the cost of funds of the bank do not increase proportionately.

13. How is the FI exposed to credit risk when it makes loan commitments? How is credit risk
related to interest rate risk? What control measure is available to the FI for the purpose of
protecting against credit risk? What is the realistic opportunity to implement this control
feature?

A bank is exposed to credit risk, because the credit quality of a borrower could decline during the
intervening period of the loan commitment. When a bank makes a loan commitment, it is
obligated to deliver the loan. Although most loan commitments today contain a clause releasing
a bank from its obligations in the event of a significant decline in credit quality, the bank may
not be inclined to use it for fear of reputation concerns. Interest rate risk is related to credit risk
because default risks are much higher during periods of increasing interest rates. When interest
rates rise, firms have to generate higher rates of return. Thus, banks making loan commitments
are subject to both risks in periods of rising interest rates.

7
14. How is an FI exposed to takedown risk and aggregate funding risk? How are these two
contingent risks related?

A bank is exposed to takedown risk because not all loan commitments are fully taken down. As a
result, a bank has to forecast its funding requirements in order not to keep funds at levels that are
too high or too low. Maintaining low levels of funds may result in paying more to obtain funds
on short notice. Maintaining high levels of funds may result in lower earnings.

Additionally, banks are exposed to aggregate funding risk, i.e., all customers may choose to take
down their loan commitments during a similar period, such as when interest rates are rising or
credit availability is low. This could cause a severe liquidity problem.

These two risks are related because takedowns usually occur when interest rates are rising. If all
customers decide to increase their takedowns, it could put a severe strain on the bank. Similarly,
when interest rates are falling, customers are likely to find cheaper financing elsewhere. Thus,
FIs should take into account the interdependence of these two events when forecasting future
funding need.

15. Do the contingent risks of interest rate, takedown, credit, and aggregate funding tend to
increase the insolvency risk of an FI? Why or why not?

These risk elements all can have adverse effects on the solvency of a bank. While they need not
occur simultaneously, there is a fairly high degree of correlation between them. For example, if
rates rise, funding will become shorter, takedowns will likely increase, credit quality of
borrowers will become lower, and the value of the typical FI will shrink.

16. What is a letter of credit? How is a letter of credit like an insurance contract?

Like most insurance contracts, a letter of credit is like a guarantee. It essentially gives the holder
the right to receive payment from the FI in the event that the original purchaser of the product
defaults on the payment. Like the seller of any guarantee, the FI is obligated to pay the
guarantee holder at the holders request.

17. A German bank issues a three-month letter of credit on behalf of its customer in Germany,
who is planning to import $100,000 worth of goods from the United States. It charges an
up-front fee of 100 basis points.

a. What up-front fee does the bank earn?

Up-front fee earned = $100,000 x 0.0100 = $1,000

b. If the U.S. exporter decides to discount this letter of credit after it has been accepted by
the German bank, how much will the exporter receive, assuming that the interest rate
currently is 5 percent and that 90 days remain before maturity?

To discount an instrument, use PV = FV (1 - (dt/365))

8
PV = (1 - (.05 * 90/365) * $100,000 = $98,767.12

c. What risk does the German bank incur by issuing this letter of credit?

The German bank faces the risk that the importer may default on its payment and it will be
obligated to make the payment at the end of 90 days. In such a case, it will incur an on-
balance sheet liability of $100,000.

18. How do standby letters of credit differ from trade letters of credit? With what other types
of FI products do SLCs compete? What types of FIs could issue SLCs?

Standby letters of credit usually are written for contingency situations that are less predictable
and that have more severe consequences than the LCs written for standard commercial trade
relationships. Often SLCs are used as performance guarantees for projects over extended periods
of time, or they are used in the issuance of financial securities such as municipal bonds or
commercial paper. Banks and property-casualty insurance companies are the primary issuers of
SLCs.

19. A corporation is planning to issue $1,000,000 of 270-day commercial paper for an effective
yield of 5 percent. The corporation expects to save 30 basis points on the interest rate by
using either an SLC or a loan commitment as collateral for the issue.

a. What are the net savings to the corporation if a bank agrees to provide a 270-day SLC
for an up-front fee of 20 basis points on the face value of the loan commitment to back
the commercial paper issue?

Cost of using SLC = (0.0020) x $1,000,000 = -$2000.00


Savings by using SLC as collateral = -(0.0030 * 270)/365 x $1,000,000) = 2219.18
Net savings = $ 219.18

b. What are the net savings to the corporation if a bank agrees to provide a 270-day loan
commitment to back the issue? The bank will charge 10 basis points for an up-front fee
and 10 basis points for a back-end fee for any unused portion of the loan. Assume the
loan is not needed.

Up-front fee of loan commitment = (0.0010) x $1,000,000 = $1000.00


Back-end fee (assuming no usage) = (0.0010) x $1,000,000 = 1000.00
= $2000.00
Savings by using loan commitments as collateral =
(0.0030 * 270)/365 x $1,000,000) = $2219.18
Net savings = $ 219.18

c. Should the corporation be indifferent to the two alternative collateral methods at the
time the commercial paper is issued?

9
Not necessarily. If some of the loan commitment is drawn down, the back-end fee will be
less, and the savings will be greater.

20. Explain how the use of derivative contracts, such as forwards, futures, swaps, and options,
creates contingent credit risk for an FI. Why do OTC contracts carry more contingent
credit risk than do exchange-traded contracts? How is the default risk of OTC contracts
related to the time to maturity and the price and rate volatilities of the underlying assets?

Credit risk occurs because of the potential for the counterparty to default on payment obligations,
a situation that would require the FI to replace the contract at the current market prices and rates.
OTC contracts typically are non-standardized or unique contracts that do not have external
guarantees from an organized exchange. Defaults on these contracts usually will occur when the
FI stands to gain and the counterparty stands to lose, i.e., when the contract is hedging the risk
exactly as the FI hoped. Thus default risk is higher when the volatility of the underlying asset is
higher.

21. What is meant by when issued trading? Explain how forward purchases of when-issued
government T-Bills can expose FIs to contingent interest rate risk.

The purchase or sale of a security before it is issued is called when issued trading. When an FI
purchases T-bills on behalf of a customer prior to the actual weekly auctioning of securities, it
incurs the risk of underpricing the security. On the day the T-bills are allotted, it is possible that
because of high demand, the prices may be much higher than what the FI has forecasted. It then
may be forced to purchase them at higher prices which means lower interest rates.

22. Distinguish between loan sales with and without recourse. Why would banks want to sell
loans with recourse? Explain how loan sales can leave banks exposed to contingent interest
rate risks.

When FIs sell loans without recourse, the buyers of the loans accept the risk of non-repayment
by the borrower. In other words, the loans are completely off the books of the FI. In the case of
loans sold with recourse, FIs are still legally responsible for the payment of the loans to the seller
in the event the borrower defaults. Banks are willing to sell such loans because they obtain better
prices and also because it allows them to remove the assets from their balance sheets. FIs are
more likely to sell such loans with recourse if the borrower of the loan is of good credit standing.
When interest rates increase, there is a higher likelihood of loan defaults and a higher probability
that the FI will have to buy back some of the loans. This may be the case even for sales of loans
without recourse because banks are reluctant not to take back loans for reputation concerns.

23. The manager of Shakey Bank sends a $2 million funds transfer payment message via
CHIPS to the Trust Bank at 10 a.m. Trust Bank sends a $2 million funds transfer message
via CHIPS to Hope Bank later that same day. What type of risk is inherent in this
transaction? How will the risk become reality?

This is an example of settlement risk. If the funds sent by Shakey do not reach the Trust bank in
time, then Trust may not have sufficient funds to cover its promised payment to Hope.

10
24. Explain how settlement risk is incurred in the interbank payment mechanism and how it is
another form of off-balance sheet risk.

Settlement risk occurs when FIs transfer and receive funds from other banks through the
FedWire system or CHIPS (Clearing House Interbank Payment System). Since all settlements
are netted out at the end of the day, FIs can engage in overdrafts during the day. This means that
if a bank defaults during the middle of the day, several banks may be caught short-ended because
they may not receive their scheduled payments. This may also cause their payments made to
other banks to be denied. The risks of such intra-day overdrafts can be solved by real-time
transfers, which should be introduced in the near future.

25. What is the difference between a one-bank holding company and a multibank holding
company? How does the principle of corporate separateness ensure that a bank is safe from
the failure of its affiliates?

A one-bank holding company (OBHC) is a holding company that has among its several
subsidiaries only one bank. In contrast, a multibank holding company (MBHC) owns several
banks. The principle of corporate separateness ensures that the affiliates are all structured as
separate entities so that the failure of one will not have a negative impact on either the holding
company or the other affiliates. This is accomplished by ensuring that each affiliate is run as a
separate entity with its own financial resources and capital.

26. Discuss how the failure of an affiliate can affect the holding company or its affiliates even
if the affiliates are structured separately.

First, creditors of the failed affiliate may claim that it is not a truly separate firm under the
estoppel argument because they could not distinguish between affiliates of the holding
company with similar names. Secondly, regulators themselves have tried to challenge the
principle of corporate separateness by asking the holding company or the other banks of the
multibank holding company to bail out the failed unit. Although not yet approved by the courts, a
future favorable ruling could undermine the separateness of the affiliates.

27. Defend the statement that although off-balance-sheet activities expose FIs to several forms
of risks, they also can alleviate the risks of banks.

Although an FI is exposed to interest rate, foreign exchange, credit, liquidity, and other risks, it
also can use these risks to help alleviate its overall risk, if used judiciously. For example, the use
of options and futures can reduce the volatility of earnings if hedged with the appropriate
amount. Such hedging can be incorporated in an FIs overall portfolio so that both trading and
hedging activities can be pursued independently while still reducing the total exposure of the
bank. It is also possible to offset the exposures of on-and off-balance-sheet activities. For
example, it is possible that decreases in interest rates could lead to increased exposures for some
assets (reinvestment risks) but they could be offset by off-balance-sheet liabilities. Thus,
regulation of off-balance-sheet activities should recognize the positive effects of these
instruments in helping ameliorate the total exposure of the FI.

11
Chapter Fourteen
Technology and Other Operational Risk

Chapter Outline

Introduction

What Are the Sources of Operational Risk?

Technological Innovation and Profitability

The Impact of Technology on Wholesale and Retail Financial Services Production


Wholesale Financial Services
Retail Financial Services

The Effect of Technology on Revenues and Costs


Technology and Revenues
Technology and Costs

Testing for Economies of Scale and Economies of Scope


The Production Approach
The Intermediation Approach

Empirical Findings on Cost Economies of Scale and Scope and Implications for Technology
Expenditures
Economies of Scale and Scope and X-Inefficiencies

Technology and the Evolution of the Payments System


Risks that Arise in an Electronic Transfer Payment System

Other Operational Risks

Regulatory Issues and Technology and Operational Risks

Summary

Md. Monjur Morshed


th
MBA 7 Batch
Dept. of Finance
University of Dhaka

1
Solutions for End-of-Chapter Questions and Problems: Chapter Fourteen

1. Explain how technological improvements can increase an FIs interest and noninterest income and
reduce interest and noninterest expenses. Use some specific examples.

Technological improvements in the services provided by financial intermediaries help increase income and
reduce costs in several ways:

(a) Interest income: By making it easier to draw down on loans directly via computers, as well as by
processing loan applications faster.

(b) Interest expense: By enabling banks to access lower cost funds that are available directly from brokers
and dealers through computers and screen-based trading.

(c) Noninterest income: By making more nonloan products available to customers through the computers
to customers such as letters of credit and commercial paper and derivatives.

(d) Noninterest expense: By reducing processing and settlement fees, an area that has changed drastically
for most FIs, especially in trading activities and in the use of automated teller machines (ATMs).

2. Table 14-1 shows data on earnings, expenses, and assets for all insured banks. Calculate the annual
growth rates in the various income, expense, earnings and asset categories from 1991 to 2003. If part
of the growth rates in assets, earnings, and expenses can be attributed to technological change, in what
areas of operating performance has technological change appeared to have the greatest impact? What
growth rates are more likely caused by economy-wide economic activity?

Growth rates through the end of 2003:

Category Nine-Year
Interest income -1.14%
Interest expense -6.62%
Net interest income 3.23%
Provision for Loan Loss -2.17%
Noninterest income 7.24%
Noninterest expenses 3.22%
Net earnings 12.74%
Average total assets 6.50%

The high growth rate in noninterest income reflects in part, the additional fees for technology oriented
products such as ATMs and other services. The growth in noninterest expense reflects a lower growth in
personnel expenses that further supports the transition toward more technology. The negative growth rates
in interest income and interest expense reflect the low interest rate environment of the economy that was
prevalent during the latter portion of the time period. The high growth rate in net earnings is partially fueled
by the negative growth in loan losses.

3. Compare the effects of technology on a banks wholesale operations with the effects of technology on a
banks retail operations. Give some specific examples.

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Generally the wholesale efforts have centered on the banks ability to improve the management of float for
the bank and for large corporate customers. These efforts include services dealing with lockboxes, funds
concentrations, treasury management software, etc. The effect on retail banking primarily has been to make
it easier for individuals to obtain banking services as exemplified by ATMs and home banking products.

4. What are some of the risks inherent in being the first to introduce a financial innovation?

One risk is that the innovation may not be successful, because of either lack of acceptance by the customers
of the bank or problems with the design and delivery of the product. If the product is successful, competitors
may be able to quickly duplicate the product without incurring similar development cost of the original
innovator. Another risk involves agency issues in which an employee recommends and/or pushes for new
products or expansion which may not be in the best interests of the shareholders.

5. The operations department of a major FI is planning to reorganize several of its back-office functions.
Its current operating expense is $1,500,000, of which $1,000,000 is for staff expenses. The FI uses a
12 percent cost of capital to evaluate cost-saving projects.

a. One way of reorganizing is to outsource overseas a portion of its data entry functions. This will
require an initial investment of approximately $500,000 after taxes. The FI expects to save
$150,000 in annual operating expenses after tax for the next 7 years. Should it undertake this
project, assuming that this change will lead to permanent savings?

This is a traditional capital budgeting problem. Investments = $500,000, and annual cost savings =
$150,000. NPV = CF* PVAk=12%, n=7 Investment, where k = banks cost of capital and CF = cash
flows or cost savings. NPV = -500,000 + $150,000 PVAk=12%, n=7 = -$500,000 + $684,563.48 =
$184,563.48. Yes, the FI should undertake this project.

b. Another option is to automate the entire process by installing new state-of-the-art computers and
software. The FI expects to realize more than $500,000 per year in after-tax savings, but the initial
investment will be approximately $3,000,000. In addition, the life of this project is limited to 7
years, at which time new computers and software will need to be installed. Using this 7-year
planning horizon, should it invest in this project? What level of after-tax savings would be
necessary to make this plan comparable in value creation to the plan in part (a)?

NPV = -$3,000,000 + PVAk=12%, n=7($500,000) = -$718,121.73. No, the FI should not undertake the
project under these terms. The level of after-tax savings necessary to make the plan comparable to part
(a) is NPV = -$3,000,000 + PVAk=12%, n=7 (Savings) = $184,563.48, Annual savings = $697,794.34
over the seven-year period.

6. City Bank upgrades its computer equipment every five years to keep up with changes in technology.
Its next upgrade is two years from today and is budgeted to cost $1,000,000. Management is
considering moving up the date by two years to install some new computers with a breakthrough
software that could generate significant savings. The cost for this new equipment also is $1,000,000.
What should be the savings per year to justify moving up the planned update by two years? Assume a
cost of capital of 15 percent

The equivalent annual cost for the planned 5 years is $1,000,000/PVAk=15, n=5 = $298,315.56. Since the cost
of the planned improvement is the same as the original investment, the savings generated should be the
present value of $298,315.56 in years 1 and 2, or a total of $484,974.26.
3
7. Identify and discuss three benefits of technology in generating revenue for FIs?

Technology (1) allows for more efficient cross-marketing of new and old products; (2) encourages an
increase in the rate of innovation of new products; and (3) supports improvements in service quality and
convenience. Many FIs use high-tech efforts to determine how they can reach more customers with more
products. As marketing lines are identified and defined, new product ideas emerge that further the
usefulness of FI products to customers.

8. Distinguish between economies of scale and economies of scope.

Economies of scale refer to the average cost of production falling as output of a firm increases, and thus
reflect the benefits of a single product firm getting larger. Economies of scope refer to the average cost of
production falling through the use of joint inputs producing multiple products, and thus reflect the benefits of
a single-product firm becoming a multi-product firm.

9. What information on the operating costs of FIs does the measurement of economies of scale provide?
If economies of scale exist, what implications do they have for regulators?

Economies of scale provide a measure of the average costs of producing a unit of output and usually are
measured as total costs over total assets, total loans, or total deposits. If average costs decline as the size of
the firm increases, large FIs will be able to offer more competitive rates than their smaller counterparts and
possibly drive them out of business. This is easier today because the costs of incorporating new technology
can be very expensive to small FIs. Regulators have to be concerned about economies of scale, because, if it
is true that larger firms have lower operating costs, policies on restricting mergers, especially vertical
mergers, may be counterproductive, since social benefits may outweigh the social costs of mergers.

10. What are diseconomies of scale? What are the risks of large-scale technological investments,
especially to large FIs? Why are small FIs willing to outsource production to large FIs against whom
they are competing? Why are large FIs willing to accept outsourced production from smaller FI
competition?

Diseconomies of scale occur when the average cost of production increases as the amount of production
increases. The risks of large-scale technological investments have to do with whether the uncertain future
cash flows will be sufficient to cover the fixed costs of development and installation of the systems. The
costs of excess capacity and cost overruns due to integration problems can easily absorb the expected from
the expansions. As a result, large FIs will accept production from smaller competitor FIs if such acceptance
will assure that the desired cost benefits are obtained. At the same time, small FIs are willing to outsource
production in an attempt to gain the benefits of lower production expenses that may be unattainable through
their own technology upgrades.

11. What information on the operating costs of FIs is provided by the measurement of economies of scope?
What implications do economies of scope have for regulators?

Economies of scope measure the synergistic cost savings to banks that offer multiple products or services.
For example, if an FI offers both banking and insurance services and offers them at lower costs than a bank
and an insurance company offering them separately, economies of scope are said to exist. For regulators, this
would mean being less restrictive on horizontal mergers where FIs are able to offer multiple services.

4
12. Buy Bank had $130 million in assets and $20 million in expenses before the acquisition of Sell Bank,
which had assets of $50 million and expenses of $10 million. After the merger, the bank had $180
million in assets and $35 million in costs. Did this acquisition generate economies of scale or
economies of scope?

Neither. The costs as a percentage of assets have increased from 15.38 percent to 19.44 percent for the bank.
This represents diseconomies of scale.

13. A bank, with assets of $2 billion and costs of $200 million has acquired an investment banking firm
subsidiary with assets of $40 million and expenses of $15 million. After the acquisition, the costs of
the bank are $180 million and the costs of the subsidiary are $20 million. Does the resulting merger
reflect economies of scale or economies of scope?

This situation would represent economies of scope since different but joint operations are involved. The
average cost of the separate firms was $215 million/$2.04 billion or 10.54 percent. After the merger, the
average costs are $200 million/$2.04 billion or 9.8 percent.

14. What are diseconomies of scope? How could diseconomies of scope occur?

Diseconomies of scope occur when the average cost of production is higher from the joint production of
services than the average costs from the previous independent production of the services. This situation can
occur if the technology used in the production of a portion of the services is not sufficiently efficient for the
production of the remaining services.

15. A survey of a local market has provided the following average cost data: Mortgage Bank A (MBA) has
assets of $3 million and an average cost of 20 percent. Life Insurance Company B (LICB) has assets of
$4 million and an average cost of 30 percent. Corporate Pension Fund C (CPFC) has assets of $4
million and an average cost of 25 percent. For each firm, average costs are measured as a proportion of
assets. MBA is planning to acquire LICB and CPFC with the expectation of reducing overall average
costs by eliminating the duplication of services.

a. What should be the average cost after acquisition for the bank to justify this merger?
Average cost:
Bank A = 0.20 x $3,000,000 = $ 600,000
Insurance Company B = 0.30 x $4,000,000 = 1,200,000
Pension Fund C = 0.25 x $4,000,000 = 1,000,000
Total costs = $2,800,000

The average cost after merger = 2,800,000/11,000,000 = 25.45 percent. If Bank A can lower its
average costs to less than 25.45 percent, it should go ahead with the merger.

b. If MBA plans to reduce operating costs by $500,000 after the merger, what will be the average cost
of the new firm?

If Bank A lowers its operating costs by $500,000, the new average cost of the new firm will be
$2,300,000/$11,000,000 = 20.91 percent.

16. What is the difference between the production approach and the intermediation approach to estimating
costs functions of FIs?
5
In the production approach, firms are assumed to use labor and capital to produce two outputs: deposits and
loans. In the intermediation approach, the function of the FI is to intermediate between borrowers and
lenders. As a result, the inputs consist of capital, labor, and deposits.

17. What are some of the conclusions of empirical studies on economies of scale and scope? How
important is the impact of cost reductions on total average costs? What are X-inefficiencies? What
role do these factors play in explaining cost differences among FIs?

Earlier studies have shown very little economies of scale except for small banks. More recent studies have
shown economies of scale to exist for banks in the $100-million to $5-billion sector. Unfortunately, tests for
these studies are very sensitive and can be influenced by the models used. Recent studies also suggest that
cost-inefficiencies (X-inefficiencies) or costs associated with managerial ineptness and other factors may
account for cost variations among FIs. Similarly, economies of scope studies are not very conclusive. Most
find no evidence of benefits to offering multiple services. Finally, it is possible that some of the cost
inefficiencies could be overshadowed by efficiencies in revenue generation.

18. Why does the United States lag behind most other industrialized countries in the proportion of annual
electronic noncash transactions per capita? What factors probably will be important in causing the gap
to decrease?

A specific reason for lagging behind the other countries is difficult to identify. However, the United States
has a much higher ratio of banks per bank customer, and these banks have been slow to provide
technological products that allow and encourage electronic transaction. Many experts believe the gap
between the United States and other countries will narrow as the effects of nationwide interstate branching
and consolidation of the financial services industry continue to be realized. Further, electronic transaction
products are becoming more available.

19. What are the differences between the Fedwire and CHIPS payment systems?
Fedwire and CHIPS both are electronic payments systems that transfer various transactions between banks.
Fedwire is comprised of domestic banks linked with the Federal Reserve System, and CHIPS is a private
consortium of the largest domestic and international banks. When FIs engage in overdrafts while using the
Fedwire system, the counterparty is safe even if the FI fails because the Federal Reserve guarantees any
payments made over the wire. However, in the case of CHIPS, the transactions are only tentative and are
confirmed only at the end of the day. In the event of a bank failure, the receipts and payments from all banks
dealing with the failed bank are tabulated again and new debits and credits are posted. Consequently, there is
a danger that a systemic default can be triggered in the event of a single failure.

20. What is a daylight overdraft? How do an FIs overdraft risks incurred during the day differ for each of
the two competing electronic payment systems, Fedwire and CHIPS? What provision has been taken
by the members of CHIPS to introduce an element of insurance against the settlement risk problem?

A daylight overdraft occurs at the Federal Reserve Bank when a bank, in the continuing process of
transferring in money and transferring out money from its account, has transferred out more money than
currently is in the account. This is similar to the retail transaction of depositing a check and withdrawing
cash before the funds from the initial check have cleared into the account. Under the Fedwire system, the
Federal Reserve System guarantees all wire transfer messages, while the private CHIPS system will unwind
transactions in the event that funds are not sufficient to cover the wire messages. To reduce the potential of a

6
serious system-wide financial crisis, the members of CHIPS have created an escrow fund to cover message
commitments of a failed bank.

21. How is Regulation F of the 1991 FDICIA expected to reduce the problem of daylight overdraft risk?

Regulation F required banks, thrifts, and foreign institutions to implement procedures to reduce their daylight
overdraft exposures. As of December 1992, banks are limited from keeping overdraft positions with a
correspondent bank to no more than 25% of the correspondent banks capital. If a bank is adequately
capitalized, then it can have exposures of up to 50% of the correspondent banks capital. For well-capitalized
banks, there is no limit.

22. Why do FIs in the U.S. face a higher degree of international technology risk than do the FIs in other
countries, especially some European countries?

The implementation of high technology systems by United States banks in Sweden and Belgium tends to be
slow because of the cost of accessing telephone transmission lines. In contrast, foreign FIs in the U.S. have
direct access to U.S. technology-based products at a low cost.

23. What has been the impact of rapid technological improvements in the electronic payment systems on
crime and fraud risk?

The massive increase in the use of electronic payment mechanisms has greatly increased the level of
sophistication required to commit unauthorized transfers by accessing computers illegally. However,
knowledge of specialized technical information has created a new type of white-collared crime and thus
security problems.

24. What are usury ceilings? How does technology create regulatory risk?

Usury ceilings are limits that FIs may charge on certain types of lending activities, such as consumer loans
and credit cards. Because many product transactions rely heavily on electronic technology, financial
products often can be marketed from locations without severe regulatory constraints. This activity in effect
circumvents the regulatory effects desired in the constrained environments.

25. How has technology altered the competition risk of FIs?

Competition in the financial services industry has increased because of the entrance of nontraditional
financial service providers through the use of technology. Thus the franchise values of traditional service
providers, such as banks, savings and loans, etc., are under increasing pressures from the new, technology
based, nontraditional providers.

26. What action has the BIS taken to protect depository institutions from insolvency due to operational
risk?

In 1999 the Basle Committee (of the BIS) on Banking Supervision said that operational risks are
sufficiently important for banks to devote necessary resources to quantify the level of such risks and to
incorporate them (along with market and credit risk) into their assessment of their overall capital adequacy.
In its follow up consultative document released in January 2001, the Basle Committee proposed three
specific methods by which depository institutions (DIs) would hold capital (effective 2005) to protect against
operational risk.
7
Chapter Fifteen
Foreign Exchange Risk

Chapter Outline

Introduction

Sources of Foreign Exchange Risk Exposure


Foreign Exchange Rate Volatility and FX Exposure

Foreign Currency Trading


FX Trading Activities
The Profitability of Foreign Currency Trading

Foreign Asset and Liability Positions


The Return and Risk of Foreign Investments
Risk and Hedging
Interest Rate Parity Theorem
Multicurrency Foreign Asset-Liability Positions

Summary

Solutions for End-of-Chapter Questions and Problems: Chapter Fifteen

1. What are the four FX risks faced by FIs?

The four risks include (1) trading in foreign securities, (2) making foreign currency loans, (3)
issuing foreign currency-denominated debt, and (4) buying foreign currency-issued securities.

2. What is the spot market for FX? What is the forward market for FX? What is the position
of being net long in a currency?

The spot market for foreign exchange involves transactions for immediate delivery of a currency,
while the forward market involves agreements to deliver a currency at a later time for a price or
exchange rate that is determined at the time the agreement is reached. The net exposure of a
foreign currency is the net foreign asset position plus the net foreign currency position. Net long
in a currency means that the amount of foreign assets exceeds the amount of foreign liabilities.

3. X-IM Bank has 14 million in assets and 23 million in liabilities and has sold 8 million
in foreign currency trading. What is the net exposure for X-IM? For what type of
exchange rate movement does this exposure put the bank at risk?

The net exposure would be 14 million 23 million 8 million = -17 million. This negative
exposure puts the bank at risk of an appreciation of the yen against the dollar. A stronger yen
means that repayment of the net position would require more dollars.

1
4. What two factors directly affect the profitability of an FIs position in a foreign currency?

The profitability is a function of the size of the net exposure and the volatility of the foreign
exchange ratio or relationship.

5. The following are the foreign currency positions of an FI, expressed in dollars.

Currency Assets Liabilities FX Bought FX Sold


Swiss franc (SF) $125,000 $50,000 $10,000 $15,000
British pound () 50,000 22,000 15,000 20,000
Japanese yen () 75,000 30,000 12,000 88,000

a. What is the FIs net exposure in Swiss francs?

Net exposure in Swiss francs = $70,000.

b. What is the FIs net exposure in British pounds?

Net exposure in British pounds = $23,000.

c. What is the FIs net exposure in Japanese yen?


Net exposure in Japanese yen = -$31,000

d. What is the expected loss or gain if the SF exchange rate appreciates by 1 percent?

If assets are greater than liabilities, then an appreciation of the foreign exchange rates will
generate a gain = $70,000 x 0.01 = $7,000.

e. What is the expected loss or gain if the exchange rate appreciates by 1 percent?

Gain = $23,000 x 0.01 = $230

f. What is the expected loss or gain if the exchange rate appreciates by 2 percent?

Loss = -$31,000 x 0.02 = -$6,200

6. What are the four FX trading activities undertaken by FIs? How do FIs profit from these
activities? What are the reasons for the slow growth in FX profits at major U.S. banks?

The four areas of FX activity undertaken by FIs are either for their customers accounts or for
their own proprietary trading accounts. They involve the purchase and sale of FX in order to (a)
complete international commercial transactions, (b) invest abroad in direct or portfolio
investments, (c) hedge outstanding currency exposures, and (d) speculate against movements in
currencies. Most banks earn commissions on transactions made on behalf of their customers. If
the banks are market makers in currencies, they make their profits on the bid-ask spread.

2
A major reason for the slow growth in profits has been the decline in volatility of FX rates among
major European currencies that has more than offset the increased volatility of FX rates among
Asian currencies. The reduced volatility is related to the reduction in inflation rates in the
European countries and the relatively fixed exchange rates that have prevailed as the European
countries move toward full monetary union.

7. City Bank issued $200 million of one-year CDs in the U.S. at a rate of 6.50 percent. It
invested part of this money, $100 million, in the purchase of a one-year bond issued by a
U.S. firm at an annual rate of 7 percent. The remaining $100 million was invested in a one-
year Brazilian government bond paying an annual interest rate of 8 percent. The exchange
rate at the time of the transaction was Brazilian real 1/$.

a. What will be the net return on this $200 million investment in bonds if the exchange
rate between the Brazilian real and the U.S. dollar remains the same?

Cost of funds = 0.065 x $200 million = $13 million

Return on U.S. loan = 0.07 x $100 million = $ 7,000,000


Return on Brazilian bond = (.08 x Real 100 m)/1.00 = $ 8,000,000
Total interest earned = $15,000,000
Net return on investment = $15 million - $13 million/$200 million = 1.00 percent.

b. What will be the net return on this $200 million investment if the exchange rate
changes to real 1.20/$?

Cost of funds = 0.065 x $200 million = $13,000,000

Return on U.S. loan = 0.07 x $100 million = $ 7,000,000


Return on Brazilian bond = (0.08 x Real 100m)/1.20 = $ 6,666,667
Total interest earned = $13,666,667

Net return on investment = $13,666,667 - $13,000,000/$200,000,000 = 0.67 percent.

Consideration should be given to the fact that the Brazilian bond was for Real100 million.
Thus, at maturity the bond will be paid back for Real100 million/1.20 = $83,333,333.33.
Therefore, the strengthening dollar will have caused a loss in capital ($16,666,666.67) that
far exceeds the interest earned on the Brazilian bond.

c. What will be the net return on this $200 million investment if the exchange rate
changes to real 0.80/$?

Cost of funds = 0.065 x $200 million = $13,000,000

Return on U.S. loan = 0.07 x $100 million = $ 7,000,000


Return on Brazilian bond = (.08 x Real 100m)/0.80 = $10,000,000

3
Total interest earned = $17,000,000

Net return on investment = $17,000,000 - $13,000,000/$200,000,000 = 2.00 percent.

Consideration should be given to the fact that the Brazilian bond was for Real100 million.
Thus, at maturity the bond will be paid back for Real100 million/0.80 = $125,000,000.
Therefore, the strengthening Real will have caused a gain in capital of $25,000,000 in
addition to the interest earned on the Brazilian bond.

8. Sun Bank USA purchased a 16 million one-year Euro loan that pays 12 percent interest
annually. The spot rate for Euros is 1.60/$. Sun Bank has funded this loan by accepting a
British pound ()-denominated deposit for the equivalent amount and maturity at an annual
rate of 10 percent. The current spot rate of the British pound is $1.60/.

a. What is the net interest income earned in dollars on this one-year transaction if the spot
rates at the end of the year are 1.70/$ and $1.85/?

. Loan amount = 16 million/1.60 = $10 million


Deposit amount = $10m/1.60 = 6,250,000
Interest income at the end of the year = 16m x 0.12 = 1.92/1.70 = $1,129,411.77
Interest expense at the end of the year = 6,250,000 x 0.10 = 625,000 x 1.85 = $1,156,250
Net interest income = $1,129,411.77 - $1,156,250.00 = -$26,838.23

b. What should be the to $ spot rate in order for the bank to earn a net interest margin of
4 percent?

A net interest margin of 4 percent would imply $10,000,000 x 0.04 = $400,000.


The net cost of deposits should be $1,129,411.77 - 400,000 = $729,411.77.
Pound rate = $729,411.77/625,000 = $1.1671/.
Thus, the pound should be selling at $1.1671/ in order for the bank to earn 4 percent.

c. Does your answer to part (b) imply that the dollar should appreciate or depreciate
against the pound?

The dollar should appreciate against the pound. It takes fewer dollars to buy one pound.

d. What is the total effect on net interest income and principal of this transaction given the
end-of-year spot rates in part (a)?

Interest income and loan principal at year-end = (16m x 1.12)/1.70 = $10,541,176.47


Interest expense and deposit principal at year-end = (6.25m x 1.10) x 1.85 = $12,718,750
Total income = $10,541,176.47 - $12,718,750.00 = -$2,177,573.53

4
9. Bank USA recently made a one-year $10 million loan that pays 10 percent interest
annually. The loan was funded with a Swiss franc-denominated one-year deposit at an
annual rate of 8 percent. The current spot rate is SF1.60/$.

a. What will be the net interest income in dollars on the one-year loan if the spot rate at
the end of the year is SF1.58/$?

Interest income and loan principal at year-end = $10m x 0.10 = $1,000,000.


Interest expense and deposit principal at year-end = (SF16,000,000 x 0.08)/1.58
= SF1,280,000/1.58 = $810,126.58.
Net interest income = $1,000,000 - $810,810.58 = $189,873.42.

b. What will be the net interest return on assets?

Net interest return on assets = $189,873.42/$10,000,000 = 0.0190 or 1.90 percent.

c. How far can the SF appreciate before the transaction will result in a loss for Bank
USA?

Exchange rate = SF1,280,000/$1,000,000 = SF1.28/$, appreciation of 20.00 percent.

d. What is the total effect on net interest income and principal of this transaction given the
end-of-year spot rates in part (a)?

Interest income and loan principal at year-end = $10m x 1.10 = $11,000,000.


Interest expense and deposit principal at year-end = (SF16,000,000 x 1.08)/1.58
= SF17,280,000/1.58 = $10,936,709.
Total income = $11,000,000 - $10,936,709 = $63,291.

10. What motivates FIs to hedge foreign currency exposures? What are the limitations to
hedging foreign currency exposures?

FIs hedge to manage their exposure to currency risks, not to eliminate it. As in the case of
interest rate risk exposure, it is not necessarily an optimal strategy to completely hedge away all
currency risk exposure. By its very definition, hedging reduces the FI's risk by reducing the
volatility of possible future returns. This narrowing of the probability distribution of returns
reduces possible losses, but also reduces possible gains (i.e., it shortens both tails of the
distribution). A hedge would be undesirable, therefore, if the FI wants to take a speculative
position in a currency in order to benefit from some information about future currency rate
movements. The hedge would reduce possible gains from the speculative position.

11. What are the two primary methods of hedging FX risk for an FI? What two conditions are
necessary to achieve a perfect hedge through on-balance-sheet hedging? What are the
advantages and disadvantages of off-balance-sheet hedging in comparison to on-balance-
sheet hedging?

5
The manager of an FI can hedge using on-balance sheet techniques or off-balance sheet
techniques. On-balance sheet hedging requires matching currency positions and durations of
assets and liabilities. If the duration of foreign-currency-denominated fixed-rate assets is greater
than similar currency denominated fixed-rate liabilities, the market value of the assets could
decline more than the liabilities when market rates rise and therefore the hedge will not be
perfect. Thus, in matching foreign currency assets and liabilities, not only do they have to be of
the same currency but also of the same duration in order to have a perfect hedge.

Advantages of off-balance-sheet FX hedging:


The use of off-balance-sheet hedging devices, such as forward contracts, enables an FI to reduce
or eliminate its FX risk exposure without forfeiting potentially lucrative transactions. On-
balance-sheet transactions result in immediate cash flows, whereas off-balance-sheet transactions
result in contingent future cash flows. Therefore, the up-front cost of hedging using off-balance-
sheet instruments is lower than the cost of on-balance-sheet transactions. Moreover, since on-
balance-sheet transactions are fully reflected in financial statements, there may be additional
disclosure costs to hedging on the balance sheet.

Off-balance-sheet hedging instruments have been developed for many types of risk exposures.
For currency risk, forward contracts are available for the majority of currencies at a variety of
delivery dates. Moreover, since the forward contract is negotiated over the counter, the
counterparties have maximum flexibility to set terms and conditions.

Disadvantages of off-balance-sheet FX Hedging:


There is some credit risk associated with off-balance-sheet hedging instruments since there is
some possibility that the counterparty will default on its obligations. This credit risk exposure is
exacerbated in negotiated markets such as the forward market, but mitigated for exchange-traded
hedging instruments such as futures contracts.

12. North Bank has been borrowing in the U.S. markets and lending abroad, thus incurring
foreign exchange risk. In a recent transaction, it issued a one-year $2 million CD at 6
percent and funded a loan in euros at 8 percent. The spot rate for the euro was 1.45/$ at
the time of the transaction.

a. Information received immediately after the transaction closing indicated that the euro
will depreciate to 1.47/$ by year-end. If the information is correct, what will be the
realized spread on the loan? What should have been the bank interest rate on the loan
to maintain the 2 percent spread? Assume adjustments in principal value are included
in the spread.

Amount of loan in = $2 million x 1.45 = 2.9 million.


Interest and principal at year-end =
2.9m x 1.08 = 3.132m/1.47 = $2,130,612.24
Interest and principal of CDs = $2m x 1.06 = $2,120,000
Net interest income = $2,130,612.24 $2,120,000 = $10,612.24
Net interest margin = $10,612.24/2,000,000 = 0.0053 or 0.53 percent.

6
In order to maintain a 2 percent spread, the interest and principal earned at 1.47/$ should
be: 2.9 (1 + x)/1.47 = 2.16 (Because 2.16 - 2.12/2.00 = 0.02)
Therefore, (1 + x) = (2.16 x 1.47)/ 2.9 = 1.0949, and x = 0.0949 or 9.49 percent

b. The bank had an opportunity to sell one-year forward marks at 1.46. What would have
been the spread on the loan if the bank had hedged forward its foreign exchange
exposure?

Net interest income if hedged = 2.9 x 1.08 = 3.132/1.46 = 2.1452m - 2.12m


= 0.0252 million, or $25,205.48
Net interest margin = .0252/2 = 0.0126, or 1.26 percent

c. What would have been an appropriate change in loan rates to maintain the 2 percent
spread if the bank intended to hedge its exposure using the forward rates?

To maintain a 2 percent spread: 2.9(1 + X)/1.46 = 2.16 => X = 8.74 percent


The bank should increase the rates to 8.74 percent and hedge with the sale of forward s to
maintain a 2 percent spread.

13. A bank purchases a six-month, $1 million Eurodollar deposit at an annual interest rate of
6.5 percent. It invests the funds in a six-month Swedish krone bond paying 7.5 percent per
year. The current spot rate is $0.18/SK.

a. The six-month forward rate on the Swedish krone is being quoted at $0.1810/SK. What
is the net spread earned on this investment if the bank covers its foreign exchange
exposure using the forward market?

Interest plus principal expense on six-month CD = $1m x (1 + 0.065/2) = $1,032,500


Principal of Swedish bond = $1,000,000/0.18 = SK5,555,555.56
Interest and principle = SK5,555,555.56 x (1 + 0.075/2) = SK 5,763,888.89
Interest and principle in dollars if hedged: SK 5,763,888.89 x 0.1810 = $1,043,263.89
Spread = $1,043,263.89-1,032,500 = $10,763.89/1 million = 0.010764, or 2.15 percent p.a.

b. What forward rate will cause the spread to be only 1 percent per year?

Net interest income should be = 0.005 x 1,000,000 = $5,000


Therefore, interest income should be = $1,032,500 + $5,000 = $1,037,500

Forward rate = SK 5,763,888.89/$1,037,500 = $0.18/SK


For the spread to remain at 1% the spot and the forward will have to be the same.

c. Explain how forward and spot rates will both change in response to the increased
spread?

7
If FIs are able to earn higher spreads in other countries and guarantee these returns by using
the forward markets, these are equivalent to risk-free investments (except for default risk).
As a result, in part (a), there will be an increase in demand for the Swedish krone in the
spot market and an increase in sale of the forward Swedish krone as more banks engage in
this kind of lending. This results in an appreciation of the spot krone and a depreciation of
the forward krone until the spread is zero for securities of equal risk.

d. Why will a bank still be able to earn a spread of one percent knowing that interest rate
parity usually eliminates arbitrage opportunities created by differential rates?

In part (b), the FI is still able to earn a spread of one percent because the risk of the
securities is not equal. The FI earns an extra one percent because it is lending to an AA-
rated firm. The dollar-denominated deposits in the Eurocurrency markets are rated higher
because these deposits usually are issued by large institutions. Thus, the one percent spread
reflects credit or default risk. If the FI were to invest in securities of equal risk in Sweden,
arbitrage would ensure that the spread is zero.

14. Explain the concept of interest rate parity? What does this concept imply about the long-
run profit opportunities from investing in international markets? What market conditions
must prevail for the concept to be valid?

Interest rate parity argues that the discounted spread between domestic and foreign interest rates
is equal to the percentage spread between forward and spot exchange rates. If interest rate parity
holds, then it is not possible for FIs to borrow and lend in different currencies to take advantage
of the differences in interest rates between countries. This is because the spot and forward rates
will adjust to ensure that no arbitrage can take place through cross-border investments. If a
disparity exists, the sale and purchase of spot and forward currencies by arbitragers will ensure
that in equilibrium interest rate parity is maintained.

15. Assume that annual interest rates are 8 percent in the United States and 4 percent in Japan.
An FI can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The spot
rate is $0.60/.

a. If the forward rate is $0.64/, how could the bank arbitrage using a sum of $1million?
What is the expected spread?

Borrow $1,000,000 in U.S. by issuing CDs


Interest and principal at year-end = $1,000,000 x 1.08 = $1,080,000

Make a loan in Japan


Interest and principal = $1,000,000/0.60 = 1,666.667 x 1.04 = 1,733,333

Purchase U.S. dollars at the forward rate of $0.64 x 1,733,333 = $1,109,333.33


Spread = $1,109,333.33 - $1,080,000 = $29,333.33/1,000,000 = 2.93%

8
b. What forward rate will prevent an arbitrage opportunity?

The forward rate that will prevent any arbitrage is given by solving the following equation:

D
(1 + r ust )
Ft = L
* St
(1+ r dmt )

Ft = [(1 + 0.08) * 0.60]/(1.04) = $0.6231/

16. How does the lack of perfect correlation of economic returns between international
financial markets affect the risk-return opportunities for FIs holding multicurrency assets
and liabilities? Referring to Table 15-4, which country pairings seem to have the highest
correlation of returns on long-term government bonds?

If financial markets are not perfectly correlated, they provide opportunities to diversify and
reduce risk from mismatches in assets and liabilities in individual currencies. The benefits of
diversification depend on the extent of the correlations. The less is the correlation, the more are
the benefits. However, FIs that only hold one or two foreign assets and liabilities cannot take
advantage of these benefits and have to hedge their individual portfolio exposures.

In order of rank, the country pairs with the highest correlations are Netherlands-Germany, United
Kingdom-United States, Netherlands-United Kingdom, Germany-United Kingdom, Netherlands-
United States, and Germany-United States.

17. What is the relationship between the real interest rate, the expected inflation rate, and the
nominal interest rate on fixed-income securities in any particular country? Refer to Table
15-4. What factors may possibly be the reasons for the relatively low correlation
coefficients?

The nominal interest rate is equal to the real interest rate plus the expected inflation rate on assets
where default risk is not an issue. The strength of correlations among countries whose
economies are considered to be the leaders of the industrialized nations is evidence that the world
capital markets among these markets are reasonably well-integrated.

18. What is economic integration? What impact does the extent of economic integration of
international markets have on the investment opportunities for FIs?

If markets are not perfectly correlated, some barriers for free trade exist between the markets and,
therefore they are not fully integrated. When markets are fully integrated, opportunities for
diversification are reduced. Also, real returns across countries are equal. Thus, diversification
benefits occur only when nominal and real rates differ between countries. This happens when
some formal or informal barriers exist to prevent the free flow of capital across countries.

19. An FI has $100,000 of net positions outstanding in British pounds () and -$30,000 in
Swiss francs (SF). The standard deviation of the net positions as a result of exchange rate

9
changes is 1 percent for the and 1.3 percent for the SF. The correlation coefficient
between the changes in exchange rates of the and the SF is 0.80.

a. What is the risk exposure to the FI of fluctuations in the /$ rate?

Since the FI has a positive position, an appreciation of the will increase the value of its
-denominated assets more than its liabilities, providing a net gain. The opposite will occur
if the depreciates.

b. What is the risk exposure to the FI of fluctuations in the SF/$ rate?

Since the FI has a negative net position in SFs, the value of its French-denominated assets
will increase in value but not as greatly as the value of its liabilities. Hence, an appreciation
of the SF will lead to a net loss. The opposite will occur if the currency depreciates.

c. What is the risk exposure if both the and the SF positions are aggregated?

Use the formula:


2 2 2 2
p = (100 ) (1 ) + (-30 ) (1.3 ) + 2(1)(1.3)(100)(-30)( 0.8) = $72,671

The FIs net position is actually $72,671. Without including correlation, the exposure is
estimated at $100,000 - $30,000 = $70,000.

20. A money market mutual fund manager is looking for some profitable investment opportunities and
observes the following one-year interest rates on government securities and exchange rates: rUS = 12%,
rUK = 9%, S = $1.50/, f = $1.6/, where S is the spot exchange rate and f is the forward exchange rate.
Which of the two types of government securities would constitute a better investment?

The U.K. securities would yield a higher return. Compared to the 12 percent return in the U.S., a U.S.
investor could convert $1,000,000 to 666,667 and invest it at 9 percent. In one year the expected return of
principal and interest is 726,667. If these pounds are sold forward at $1.6/, the investor will lock in
$1,162,667 for a 16.2 percent return.

Md. Monjur Morshed


MBA 7th Batch
Dept. of Finance
University of Dhaka

10
Chapter Sixteen
Sovereign Risk
Solutions for End-of-Chapter Questions and Problems: Chapter Sixteen

1. What risks are incurred when making loans to borrowers based in foreign countries?
Explain.

When making loans to borrowers in foreign countries, two risks need to be considered. First, the
credit risk of the project needs to be examined to determine the ability of the borrower to repay
the money. This analysis is based strictly on the economic viability of the project and is similar in
all countries. Second, unlike domestic loans, creditors are exposed to sovereign risk. Sovereign
risk is defined as the uncertainty associated with the likelihood that the host government may not
make foreign exchange available to the borrowing firm to fulfil its payment obligations. Thus,
even though the borrowing firm has the resources to repay, it may not be able to do so because of
actions beyond its control. Thus, creditors need to account for sovereign risk in their decision
process when choosing to invest abroad.

2. What is the difference between debt rescheduling and debt repudiation?

Loan repudiation refers to a situation of outright default where the borrower refuses to make any
further payments of interest and principal. In contrast, loan rescheduling refers to temporary
postponement of payments during which time new terms and conditions are agreed upon between
the borrower and lenders. In most cases, these new terms are structured to make it easier for the
borrower to repay.

3. Identify and explain at least four reasons why rescheduling debt in the form of loans is
easier than debt in the form of bonds.

The reasons why it is easier to reschedule debt in the form of bank loans than bonds, especially in
the context of post-war lending in international financial markets, include:

a) Loans usually are made by a small group (syndicate) of banks as opposed to bonds that are
held by individuals and institutions that are geographically dispersed. Even though
bondholders usually appoint trustees to look after their interests, it has proven to be much
more difficult to approve renegotiation agreements with bondholders in contrast to bank
syndicates.

b) The group of banks that dominate lending in international markets is limited and hence able
to form a cohesive group. This enables them to act in a unified manner against potential
defaults by countries.

c) Many international loans, especially those made in the post-war period, contain cross-
default clauses, which make the cost of default very expensive to borrowers. Defaulting on
a loan would trigger default clauses on all loans with such clauses, preventing borrowers
1
from selectively defaulting on a few loans.

d) In the case of post-war loans, governments were reluctant to allow banks to fail. This meant
that they would also be actively involved in the rescheduling process by either directly
providing subsidies to prevent repudiations or providing incentives to international
agencies like the IMF and World Bank to provide other forms of grants and aid.

4. What two country risk assessment models are available to investors? How is each model
compiled?

The Euromoney Index was originally published as the spread of the Euromarket interest rate for a
particular countrys debt over LIBOR. The index was adjusted for volume and maturity. The
index recently has been replaced by a large number of subjectively determined economic and
political factors.

The Institutional Investor Index is based on surveys of the loan officers of major multinational
banks who subjectively give estimates of the credit quality of given countries. The scores range
from 0 for certain default to 100 for no probability of default.

5. What types of variables normally are used in a CRA Z-score model? Define the following
ratios, and explain how each is interpreted in assessing the probability of rescheduling.

The models typically use micro- and macroeconomic variables that are considered important in
explaining the probability of a countrys credit rescheduling.

a. Debt service ratio. The debt service ratio (DSR) divides interest plus amortization on
debt by exports. Because interest and debt payments normally are paid in hard
currencies generated by exports, a larger ratio is interpreted as a positive signal of a
pending debt rescheduling possibility.

b. Import ratio. The import ratio (IR) divides total imports by total foreign exchange
reserves. A growing amount of imports relative to FX reserves indicates a greater
probability of credit restructuring. This ratio is positively related to debt rescheduling.

c. Investment ratio. The investment ratio (INVR) measures the investment in real or
productive assets relative to gross national productive. A larger investment ratio is
considered a signal that the country will be less likely to require rescheduling in the
future because of increased productivity; thus the relationship is negative. However,
because the bargaining position of the country will be enhanced, some observers feel
that the relationship is positive. That is, a stronger ratio gives the country more power
to request, even demand, rescheduling to achieve even better terms on its debt.

d. Variance of export revenue. Export revenues are subject to both quantity and price risk
due to demand and supply factors in the international markets. Increased variance is

2
interpreted as a positive signal that rescheduling will occur because of the decreased
certainty that debt payments will be made on schedule.
e. Domestic money supply growth. Rapid domestic money supply growth indicates an
increase in inflationary pressures which typically means a decrease in the value of the
currency in international markets. Thus, real output often is negatively impacted, and
the probability of rescheduling increases.

6. What are the shortcomings introduced by using traditional CRA models and techniques?
How does each of the problems impact the estimation techniques? In each case, what
adjustments are made in the estimation techniques to compensate for the problems?

The following six items often are listed as problems in using these statistical models. First,
measuring the variables accurately and in a timely manner often is difficult because of data
accessibility. Second, the choice of rescheduling or not rescheduling often is not a dichotomous
situation. In effect, many other payment alternatives may be available through negotiation.
Third, political risk factors are extremely difficult to quantify. Fourth, the portfolio affects of
lending to more than one country are not considered. Thus the true amount of systematic risk
added to the portfolio may be less than estimated by evaluating the rescheduling probability of
countries independently. Fifth, statistical models are ill-prepared or designed to evaluate the
incentives of both the borrowers and the lenders to negotiate a rescheduling of the debt.
Borrowers benefit by lowering the present value of future payments at the expense of reducing
the openness of the market to future borrowing as well as withstanding potentially adverse effects
on trade. Lenders benefit by avoiding a possible default, collecting additional fees, and perhaps
realizing tax benefits. Lenders, however, may also be subject to greater scrutiny by regulatory
authorities and may have permanent changes in the maturity structure of their asset portfolios.
Finally, many of the key variables suffer from the problem of stability. That is, predictive
performance in the past may not be good indicators of predictive performance in the future.

7. An FI manager has calculated the following values and weights to assess the credit risk and
likelihood of having to reschedule the loan. From the Z-score calculated from these
weights and values, is the manager likely to approve the loan? Validation tests of the Z-
score model indicated scores below 0.500 likely to be nonreschedulers, while scores above
0.700 indicated a likelihood of rescheduling. Scores between 0.500 and 0.700 do not
predict well.

Country
Variable Value Weight
DSR 1.25 0.05
IR 1.60 0.10
INVR 0.60 0.35
VAREX 0.15 0.35
MG 0.02 0.15

Z = 0.05DSR + 0.15IR + 0.30INVR + 0.35VAREX + 0.15MG

3
= 0.05(1.25) + 0.15(1.60) + 0.30(0.60) + 0.35(0.15) + 0.15(0.02)
= 0.488
This score classifies the borrower as a probable nonrescheduler.
8. Countries A and B have exports of $2 and $6 billion, respectively. The total interest and
amortization on foreign loans for both countries are $1 and $2 billion, respectively.

a. What is the debt service ratio (DSR) for each country?

Interest Plus Amortizati on


DSR =
Total Exports
DSRA = $1/$2 = 0.50 DSRB = $2/$6 = 0.33

b. Based only on this ratio, to which country should lenders charge a higher risk premium?

Based on the above information, lenders should charge a higher risk premium on loans to
Country A because it has more interest and amortization payments due as a percentage of
total exports.

c. What are the shortcomings of using only these ratios to determine your answer in (b)?

This is a very static model and such a preliminary conclusion could be misleading. It is also
necessary to consider other factors which may be more favorable for Country A. Looking
forward, it is also possible that Country A may be at its developing stage where imports and
loans are needed to increase future exports. Historically, most of the industrialized
countries were net importers of capital during their developing stages. Without a
comprehensive analysis of the fundamentals, it is not possible to judge the quality of the
borrower.

9. Explain the following relation:


p = f (IR, INVR)
+, + or -
p = Probability of rescheduling
IR = Total imports / Total foreign exchange reserves
INVR = Real investment/GNP

This relation states that the probability of a countrys rescheduling of its foreign debt is a
positive function of IR but it may be positively or negatively related to INVR:

IR = Total imports/Total FX reserves. If imports as a percentage of FX reserves increase,


it leaves less foreign exchange for payments of debt. As a result, there is a higher
likelihood that the country may have to reschedule its debt.

INVR = Real investment/GNP. If a country has higher savings and higher investments, it
should lead to higher growth, reducing the likelihood of rescheduling. This supports the
4
negative sign of the relationship. On the other hand, it is possible that the higher growth
puts the country in a stronger bargaining position with its lenders and, consequently, it
may be less intimidated by the threat of default. This may make the likelihood of
rescheduling higher, suggesting a positive relationship between p and INVR.
10. What is systematic risk in terms of sovereign risk? Which of the variables often used in
statistical models tend to have high systematic risk? Which variables tend to have low
systematic risk?

Systematic risk refers to the risk effects that cannot be diversified away by lending to more than
one country. In effect, some international economic situations will affect the economies of less
developed countries in a similar manner. Economic research indicates that the DSR and the
VAREX both have high systematic risk elements. Money supply growth and the import ratio
seem to have low systematic risk elements.

11. What are the benefits and costs of rescheduling to the following?

a. A borrower?

Benefits and costs to the borrower: (a) It could reduce its immediate payments and increase
imports for the present. It could also reduce the overall payments, depending on the
rescheduling agreements. (b) It could result in either no loans being approved in the future
or the imposition of more stringent requirements. It could also result in higher premiums on
other trade instruments, such as letters of credit.

b. A lender?

Benefits and costs to the lenders: (a) It improves the likelihood that the lender will receive
full payment of its interest and principal as opposed to an outright default. (b) The
restructured loan, on a present value basis, may be higher then the existing present value of
the loan. (c) There may be tax advantages to writing off some portions of the loan, so the
present value of the complete package may be higher than the current present value of the
loan. (d) Banks may be stuck holding loans that are of longer maturity with higher risk.
e) Rescheduled loans may be a burden on the lenders remaining assets, and markets may
penalize the lender for holding on to loans that are hard to dispose of.

12. How do price and quantity risks affect the variability of a countrys export revenue?

Quantity risk refers to the variability in the amount of a commodity produced. This is most likely
to be found in agricultural products subject to favorable and unfavorable weather conditions.
Price risk refers to the variability in the commodity price due to changes in market conditions,
e.g., competitors supply changes or consumer demand changes.

13. The average ER (or VAREX = variance of export revenue) of a group of countries has
2

been estimated at 20 percent. The individual VAREX of two countries in the group,
5
Holland and Singapore, has been estimated at 15 percent and 28 percent, respectively. The
regression of individual country VAREX on the average VAREX provides the following
beta (coefficient) estimates:
H = Beta of Holland = 0.80; S = Beta of Singapore = 0.20.
a. Based only on the VAREX estimates, which country should be charged a higher risk
premium? Explain.

Based on the VAREX measure alone, risk premiums should be lower for loans made to the
Netherlands because its VAREX is lower than Singapores. VAREX measures the
volatility of the export revenues and is one measure of the ability of countries to repay
foreign debt.

b. If FIs include systematic risk in their estimation of risk premiums, how would your
conclusions to part (a) be affected? Explain.

Since the systematic beta of Singapore is lower than that of the Netherlands, it will reduce
the overall systematic risk of an FIs portfolio of foreign loans. In this case, it benefits the
FI to add Singapore to its list of countries because its unsystematic risk can be diversified
away. Thus, if the industrialized countries, including the Netherlands, are experiencing a
recession and a decline in export revenues, Singapores exports are likely to be unaffected
as evidenced by the low beta. This implies that the debt repayments between these two
countries are not highly correlated, helping to reduce the banks total risk.

14. Who are the primary sellers of LDC? Who are the buyers? Why are FIs often both sellers
and buyers of LDC debt in the secondary markets?

The primary sellers of LDC debt include large FIs who are willing to accept write-downs of loans
and small FIs who no longer wish to be involved with the LDC market. Buyers tend to be
wealthy investors, hedge funds, FIs, and corporations who wish to use debt-equity swaps to
further investment goals. FIs that are both buyers and sellers often do so to readjust their balance
sheets to meet corporate goals.

15. Identify and describe the four market segments of the secondary market for LDC debt.

Brady bonds are recollateralized loans that have lower coupon interest rates and longer maturities
than the original loans. The principal usually is collateralized with the purchase of U.S. treasury
bonds by the issuing country. Although yields are lower, the Brady bonds have more
acceptability in the secondary markets than the original loans.

Sovereign bonds constitute the second largest segment of the LDC debt market. These bonds are
issued to repay Brady bonds, and thus they have higher credit risk premiums because they no
longer have the cost of the U.S. treasury collateral.

Performing loans are the original or restructured sovereign loans on which the originating
6
country continues to remain current in the payment of interest and principal.

Nonperforming loans are traded in the secondary markets at deep discounts because of
nonpayment situations.

The following questions and problems are based on material presented in Appendix 16-A.

16. What are the risks to an investing company participating in a debt-equity swap?

Debt-equity swap investors often face long periods before they can repatriate dividends, often
have large withholding tax restrictions, have the long-term problem of potential expropriation or
nationalization of assets, and face significant foreign exchange currency risk.

17. Chase Bank holds a $200 million loan to Argentina. The loans are being traded at bid-offer
prices of 91-93 per 100 in the London secondary market.

a. If Chase has an opportunity to sell this loan to an investment bank at a 7 percent


discount, what are the savings after taxes compared to selling the loan in the secondary
market? Assume the tax rate is 40 percent.

The price that Chase could obtain from the investment bank is $200(1 0.07) = $186m.
The tax loss benefit is $14m x 0.40 = $5.6m, for a net price of $186m + $5.6 = $191.60.
In the secondary market, it would have had to sell the loans at 91cents on the dollar or $182
million. The tax loss benefit is $18m x 0.40 = $7.2m for a net price of $189.20. Therefore,
the savings from selling the loans to the investment bank as opposed to the secondary
market is $191.60 - $189.20 = $2.4 million.

b. The investment bank in turn sells the debt at a 6 percent discount to a real estate
company planning to build apartment complexes in Argentina. What is the profit after
taxes to the investment bank?

The investment bank purchased the loan for $186 million, and it sells the loan for $188
million ($200m(1 0.06) = $188m). Thus profit before taxes is $188 - $186 = $2 million,
and profit after taxes is $2(1 - 0.40) = $1.20 million.

c. The real estate company converts this loan into pesos under a debt-equity swap
organized by the Argentinean government. The official rate for dollar to peso
conversion is P1.05/$. The free market rate is P1.10/$. How much did the real estate
company save by investing in Argentina through the debt-equity swap program as
opposed to directly investing $200 million using the free market rates?

If the real estate company had invested directly, it would have received $200 x 1.10 = 220
million pesos. By purchasing through the debt-equity swap, the company pays $188 million

7
and receives $200 x 1.05 = 210 million pesos, for an equivalent rate of 210/188 = P1.117/$.
Thus, it still saves by purchasing through the debt-for-equity swap (P1.117/$ > P1.10/$).

d. How much would Chase benefit from doing a local currency debt-equity swap itself?
Why doesnt the bank do this swap?
Assuming the bank could convert the loan at $188 million in to pesos at P1.05/$, the after
tax effect would be $188m plus the tax loss benefit = $188m + $12(0.40) = $192.8 million.
The actual benefit was $191.6 million. Thus the bank would gain $1.2 million.

Chase is not allowed to participate in real equity purchases in other countries by Federal
Reserve Regulation K, nor is it allowed to engage in commerce in other countries. Further,
a long-term pesos-denominated position on the balance sheet may create more credit,
liquidity, and foreign exchange risk than the benefits are worth.

18. Zlick Company plans to invest $20 million in Chile to expand its subsidiarys
manufacturing output. Zlick has two options. It can convert the $20 million at the current
exchange rate of 410 pesos to a dollar, (i.e., P410/$), or it can engage in a debt-equity swap
with its bank City Bank by purchasing Chilean debt and then swapping that debt into
Chilean equity investments.

a. If City Bank quotes bid-offer prices of 94-96 for Chilean loans, what is the bank
expecting to receive from Zlick Corporation (ignore taxes)? Why would City Bank
want to dispose off this loan?

City Bank expects to receive 96 cents to the dollar since it is selling this loan, i.e. 0.96 x
20m = $19.20 million. It may wish to sell this loan to reduce its portfolio of troubled or bad
quality assets. As U.S. banks experienced problems with several of their foreign loans, their
choices were limited to either writing off the loans or disposing of them. The development
of an active secondary market has made it easier for FIs to sell them at a discount and
rearrange their composition of loans.

b. If Zlick decides to purchase the debt from City Bank and convert it to equity, it will
have to exchange it at the official rate of P400/$. Is this option better than investing
directly in Chile at the free market rate of P410/$?

If exchanged at market rates: $20m x P410 = P8,200 million, for an effective rate of
P410/$. If exchanged through a debt-for-equity swap: $20m x P400 = P8,000 million, for
an effective price of 8,000/19.20 = P416.67/$. Therefore, Zlick should choose the debt-for-
equity swap option.

c. What official exchange rate will cause Zlick to be indifferent between the two options?

For the options to be equal, the effective price must be:

8
(20 * x)/19.20 = 410 => x = (410 x 19.20)/20 = P393.60/$

The Chilean government could reduce the official rate to as low as P393.60/$ and the two
options will still be equal. This is because the discount obtained from the secondary market
is substantial.
19. What is concessionality in the process of rescheduling a loan?

Concessionality refers to the net cost to the FI in restructuring a loan. The amount of
concessionality is determined by subtracting the present value of the restructured loan from the
present value of the original loan.

20. Which variables typically are negotiation points in an LDC multiyear restructuring
agreement (MYRA)? How do changes in these variables provide benefits to the borrower
and to the lender?

The five common elements typically found in the MYRA negotiation include:

(a) A fee charged by the bank to cover the cost of the restructuring.

(b) The interest rate on the loan is usually lowered to allow easier repayment of the loan by the
borrowing country.

(c) A grace period may be created to allow the country to build a reserve of hard currency from
which it can repay the loan.

(d) The maturity of the loan normally is lengthened. This process reduces the periodic
payment stream for the borrower country.

(e) Various option and guarantee features may allow the lender to choose the currency for
repayment, and/or to provide protection in the case of default.

21. How would the restructuring, such as rescheduling, of sovereign bonds affect the interest
rate risk of the bonds? Is it possible that such restructuring would cause the banks cost of
capital not to change? Explain.

To the extent that the bonds have increased maturity and lower interest rates, the duration of
these bonds will have increased. Thus the interest rate risk will have increased. While it is
possible that the banks cost of capital will not change, a bank with a significant portion of its
assets in LDC debt that has been restructured will likely find an adverse adjustment in its cost of
capital.

22. A bank is in the process of renegotiating a loan. The principal outstanding is $50 million
and is to be paid back in two installments of $25 million each, plus interest of 8 percent.

9
The new terms will stretch the loan out to 5 years with no principal payments except for
interest payments of 6 percent for the first three years. The principal will be paid in the last
two years in payments of $25 million along with the interest. The cost of funds for the
bank is 6 percent for both the old loan and the renegotiated loan. An up-front fee of 1
percent is to be included for the renegotiated loan.
a. What is the present value of the existing loan for the bank?

The present value of the loan prior to rescheduling is:


Payment in Year 1: Principal + Interest = $25m + 0.08 * $50 = $29m
Payment in Year 2: Principal + Interest = $25m + 0.08 * $25 = $27m
PV = PVn=1, k=6 ($29) + PVn=2, k=6 ($27) = $51.3884 million

b. What is the present value of the rescheduled loan for the bank?

Interest payments in years 1, 2 and 3: 0.06 x $50 = $3m


Payment in Year 4: Principal + Interest = $25m + 0.06 * $50 = $28m
Payment in Year 5: Principal + Interest = $25m + 0.06 * $25 = $26.5m
PV = PVA n=3, k=6 ($3) + PVn=4, k=6 ($28) + PVn=5, k=6 ($26.5) = $50 million
Up-front fee = 0.01 x $50 = $0.50 million
PV (total) = $50.50 million

c. Is the concessionality positive or negative for the bank?

Concessionality = PVo - PVR = PV of old loan - PV of rescheduled loan


= $51.3884 - $50.50 = $0.884 million

23. A bank is in the process of renegotiating a three-year nonamortizing loan. The principal
outstanding is $20 million, and the interest rate is 8 percent. The new terms will extend the
loan to 10 years at a new interest rate of 6 percent. The cost of funds for the bank is 7
percent for both the old loan and the renegotiated loan. An up-front fee of 50 basis points
is to be included for the renegotiated loan.

a. What is the present value of the existing loan for the bank?

PV of old loan = PVIFAn=3,k=7%($1.6m) + PVIF n=3,k=7%($20m) = $20.5249 million

b. What is the present value of the rescheduled loan for the bank?

PV of new loan = PVIFAn=10,k=7%($1.2m) + PVIFn=10,k=7%($20m) + up-front fee of $0.10m


= $18.5953 million + $0.10 million = $18.6953 million

c. What is the concessionality for the bank?

10
Concessionality = $20.5249m - $18.6953m = $1.8296 million

d. What should be the up-front fee to make the concessionality zero?

Concessionality = $20.5249m - $18.5953m - x = 0 x = $1.9296 million or 9.65 percent.


24. A $20 million loan outstanding to the Nigerian government is currently in arrears with City
Bank. After extensive negotiations, City Bank agrees to reduce the interest rates from 10
percent to 6 percent and to lengthen the maturity of the loan to 10 years from the present 5
years remaining to maturity. The principal of the loan is to be paid at maturity. There will
no grace period and the first interest payment is expected at the end of the year.

a. If the cost of funds is 5 percent for the bank, what is the present value of the loan prior
to the rescheduling?

Interest payments in years 1 - 5: 0.10 x $20 = $2m


PV = PVAn=5,k=5($2) + PVn=5,k=5($20) = $24.3295 million

b. What is the present value of the rescheduled loan to the bank?

Interest payments in years 1 - 10: 0.06 x $20 = $1.2m


PV = PVA n=10,k=5($1.2) + PV n=10,k=5($20) = $21.5443 million

c. What is the concessionality of the rescheduled loan if the cost of funds remain at 5
percent and an up-front fee of 5 percent is charged?

Up-front fee = 0.05 x $20m = $1 million


PV (total) = $21.5443 million + $1 million = $22.5443 million
Concessionality = PVo - PVR = PV of old loan - PV of rescheduled loan
= $24.3259 - $22.5443 = $1.7852 million

d. What up-front fee should the bank charge to make the concessionality equal zero?

The bank has to increase its up-front fees by $1.7852 for a total of $2.7852, or 13.93%.

25. A bank was expecting to receive $100,000 from its customer based in Germany. Since the
customer has problems repaying the loan immediately, the bank extends the loan for
another year at the same interest rate of 10 percent. However, in the rescheduling
agreement, the bank reserves the right to exercise an option of receiving the payment in
deutsche marks, DM181,500, converted at the current exchange rate of DM1.65/$.

a. If the cost of funds to the bank is also assumed to be 10 percent, what is the value of
this option built into the agreement if only two possible rates are expected at the end of
the year, DM1.75/$ or DM1.55/$, with equal probability?

11
Without the option, the amount expected at the end of the year = $110,000. If the mark
depreciates to DM1.75/$, the amount received by the bank is the maximum of $110,000, or
181,500/1.75 = $103,714.29. If the mark appreciates to DM1.55/$, the amount received by
the bank is the maximum of $110,000, or 181,500/1.55 = $117,096.77. With the option,
the expected amount received is 0.50($110,000) + 0.50($117,096.77) = $113,548.39. The
present value of the option is $113,548.39 - $110,000 = $3,548.39/1.1 = $3,225.81

b. How would your answer differ, if the probability of the DM being DM1.75/$ is 70%
and DM1.55/$ is 30%?

With the option, the expected amount received is 0.70($110,000) + 0.30($117,096.77) =


$112,129.03. The present value of the option = $112,129.03 - $110,000 = $2,129.03/1.1 =
$1,935.48.

c. Does the currency option have more or less value as the volatility of the exchange rate
increases?

The option will have more value as the volatility of the exchange rate increases.

26. What are the major benefits and costs of loan sales to an FI?

The benefits of loan sales to an FI:


(a) They remove bad loans from the balance sheet, freeing resources for other investments as
well as improving the FIs portfolio composition.

(b) They may signal to market investors that the bank is in a position to bear losses. This
hypothesis has been confirmed by empirical studies showing stock prices reacting favorably
to news of banks adding additional reserves to cover loan reserves.

(c) Losses can be deducted, providing write-offs for the bank.

The costs of loan sales to an FI:


(a) There is an actual loss equal to the face value less the market value.

(b) Secondary loan prices are very volatile and can fluctuate dramatically, making the planning
of the optimal time to sell-off difficult.

27. What are the major costs and benefits of converting debt to Brady bonds for an FI?

The advantage of converting debt to a Brady bond for an FI is its increased liquidity, which
makes it an attractive instrument to hold. Brady bonds are also cleared through two major
clearing houses, Euroclear and Cedel, resulting in lower transaction costs and lower bid-ask

12
prices. A disadvantage is that Brady bonds have much longer maturities and there is usually a
loss entailed because the restructured value of the bond is usually lower than the present value of
the loan.

- 13
Chapter Seventeen
Liquidity Risk
Chapter Outline

Introduction

Causes of Liquidity Risk

Liquidity Risk at Depository Institutions


Liability-Side Liquidity Risk
Asset-Side Liquidity Risk
Measuring a DIs Liquidity Exposure
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs
Bank Runs, the Discount Window, and Deposit Insurance

Liquidity Risk and Life Insurance Companies

Liquidity Risk and Property-Casualty Insurers

Mutual Funds

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter Seventeen

1. How does the degree of liquidity risk differ for different types of financial institutions?

Depository institutions are the FIs most exposed to liquidity risk. Mutual funds, pension funds,
and PC insurance companies are the least exposed. In the middle are life insurance companies.

2. What are the two reasons liquidity risk arises? How does liquidity risk arising from the
liability side of the balance sheet differ from liquidity risk arising from the asset side of the
balance sheet? What is meant by fire-sale prices?

Liquidity risk occurs because of situations that develop from economic and financial transactions
that are reflected on either the asset side of the balance sheet or the liability side of the balance
sheet of an FI. Asset-side risk arises from transaction that result in a transfer of cash to some
other asset, such as the exercise of a loan commitment or a line of credit. Liability-side risk
arises from transactions whereby a creditor, depositor, or other claim holder demands cash in
exchange for the claim. The withdrawal of funds from a bank is an example of such a
transaction. A fire-sale price refers to the price of an asset that is less than the normal market
price because of the need or desire to sell the asset immediately under conditions of financial
distress.

3. What are core deposits? What role do core deposits play in predicting the probability
distribution of net deposit drains?

Core deposits are those deposits that will stay with the bank over an extended period of time.
These deposits are relatively stable sources of funds and consist mainly of demand, savings, and
retail time deposits. Because of their stability, a higher level of core deposits will increase the
predictability of forecasting net deposit drains from the bank.

4. The probability distribution of the net deposit drain of a DI has been estimated to have a
mean of 2 percent and a standard deviation of 1 percent. Is this DI increasing or decreasing
in size? Explain.

This DI is decreasing in size because less core deposits are being added to the bank than are
being withdrawn. On average, the rate of decrease of deposits is 2 percent. If the distribution is
normal, we can state with 95 percent confidence that the rate of decrease of deposits will be
between 0 percent and 4 percent (plus or minus two standard deviations).

5. How is the DI's distribution pattern of net deposit drains affected by the following?

a. The holiday season. The entire distribution shifts to the right (an increase in the
expected amount of withdrawals) as individuals spend more. Moreover, the standard
deviation decreases as the distribution narrows.

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b. Summer vacations. The entire distribution shifts to the right (an increase in the
expected amount of withdrawals) as individuals spend more. Moreover, the standard
deviation decreases as the distribution narrows.

c. A severe economic recession. The entire distribution shifts to the left and may have a
negative mean value as withdrawals average more than deposits. However, as the
opportunity cost of holding money declines, some depositors may increase their net
deposits. The impact will be to widen the distribution.

d. Double-digit inflation. The entire distribution shifts to the left and may have a negative
mean value as withdrawals average more than deposits. Inflation may cause a general
flight from money that will cause the distribution to narrow.

6. What are two ways a DI can offset the liquidity effects of a net deposit drain of funds?
How do the two methods differ? What are the operational benefits and costs of each
method?

If the DI has a net deposit drain, it needs to either increase its liabilities (by borrowing funds or
issuing equity) or reduce its assets. An institution can reduce its assets by drawing down on its
cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase
liabilities by issuing more Federal funds, long-term debt, or new issues of equity. If a DI offsets
the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the
drain by reducing its assets, the size of the firm is reduced. If it has a net negative deposit drain,
then it needs to follow the opposite strategy.

The operational benefit of addressing a net deposit drain is to restore the financial stability and
health of the DI. However, this process does not come without costs. On the asset side,
liquidating assets may occur only at fire-sale prices that will result in realized losses of value, or
asset-mix instability. Further, not renewing loans may result in the loss of profitable
relationships that could have negative affects on profitability in the future. On the liability side,
entering the borrowed funds market normally requires paying market interest rates that are above
those rates that it had been paying on low interest deposits.

7. What are three ways a DI can offset the effects of asset-side liquidity risk such as the
drawing down of a loan commitment?

A DI can use either liability management or reserve adjustment strategies. Liability management
involves borrowing funds in the money/purchased funds market. Reserve adjustments involve
selling cash-type assets, such as treasury bills, or simply reducing excess cash reserves to the
minimum level required to meet regulatory imposed reserve requirements.

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8. A DI with the following balance sheet (in millions) expects a net deposit drain of $15
million.
Assets Liabilities and Equity
Cash $10 Deposits $68
Loans $50 Equity $7
Securities $15
Total Assets $75 Total Liabilities & Equity $75

Show the DI's balance sheet if the following conditions occur.

a. The DI purchases liabilities to offset this expected drain.

If the DI purchases liabilities, then the new balance sheet is:


Cash $10 Deposits $53
Loans $50 Purchased liabilities $15
Securities $15 Equity $7

b. The stored liquidity management method is used to meet the liquidity shortfall.

If the DI uses reserve asset adjustment, a possible balance sheet may be:
Loans $50 Deposits $53
Securities $10 Equity $7

DIs will most likely use some combination of these two methods.

9. AllStarBank has the following balance sheet (in millions):

Assets Liabilities and Equity


Cash $30 Deposits $110
Loans $90 Borrowed funds $40
Securities $50 Equity $20
Total Assets $170 Total Liabilities & Equity $170

AllStarBanks largest customer decides to exercise a $15 million loan commitment. How
will the new balance sheet appear if AllStar uses the following liquidity risk strategies?

a. Asset management.

Assets Liabilities and Equity


Cash $30 Deposits $110
Loans $105 Borrowed funds $40
Securities $35 Equity $20
Total Assets $170 Total Liabilities & Equity $170

203
b. Liability management.

Assets Liabilities and Equity


Cash $30 Deposits $110
Loans $105 Borrowed funds $55
Securities $50 Equity $20
Total Assets $185 Total Liabilities & Equity $185

10. A DI has assets of $10 million consisting of $1 million in cash and $9 million in loans. The
DI has core deposits of $6 million, subordinated debt of $2 million, and equity of $2
million. Increases in interest rates are expected to cause a net drain of $2 million in core
deposits over the year?

a. The average cost of deposits is 6 percent and the average yield on loans is 8 percent.
The DI decides to reduce its loan portfolio to offset this expected decline in deposits.
What will be the net effect on interest income and the size of the firm after the
implementation of this strategy?

Assuming that the decrease in loans is offset by an equal decrease in deposits, the cost of
the drain = (0.08 0.06) x $2 million = $40,000. The average size of the firm will be $8
million after the drain.

b. If the interest cost of issuing new short-term debt is expected to be 7.5 percent, what
would be the effect on net interest income of offsetting the expected deposit drain with
an increase in interest-bearing liabilities?

Cost of the drain = (0.075 0.06) x $2 million = $30,000.

c. What will be the size of the DI after the drain using this strategy?

The average size of the firm will be $10 million after the drain.

d. What dynamic aspects of bank management would further support a strategy of


replacing the deposit drain with interest-bearing liabilities?

Purchasing interest-bearing liabilities may cost significantly more than the cost rate on
deposits that are leaving the bank. However, using interest-bearing deposits protects the
bank from decreasing asset size or changing the composition of the asset side of the
balance sheet.

11. Define each of the following four measures of liquidity risk. Explain how each measure
would be implemented and utilized by a DI.

a. Sources and uses of liquidity.

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This statement identifies the total sources of liquidity as the amount of cash-type assets that
can be sold with little price risk and at low cost, the amount of funds it can borrow in the
money/purchased funds market, and any excess cash reserves over the necessary reserve
requirements. The statement also identifies the amount of each category the bank has
utilized. The difference is the amount of liquidity available for the bank. This amount can
be tracked on a day-to-day basis.

b. Peer group ratio comparisons

Banks can easily compare their liquidity with peer group banks by looking at several easy
to calculate ratios. High levels of the loan to deposit and borrowed funds to total asset
ratios will identify reliance on borrowed funds markets, while heavy amounts of loan
commitments to assets may reflect a heavy amount of potential liquidity need in the future.

c. Liquidity index.

The liquidity index measures the amount of potential losses suffered by a DI from a fire-
sale of assets compared to a fair market value established under the conditions of normal
sale. The lower is the index, the less liquidity the DI has on its balance sheet. The index
should always be a value between 0 and 1.

d. Financing gap and financing requirement

The financing gap can be defined as average loans minus average deposits, or alternatively,
as negative liquid assets plus borrowed funds. A negative financing gap implies that the
bank must borrow funds or rely on liquid assets to fund the bank. Thus the financing
requirement can be expressed as financing gap plus liquid assets. This relationship implies
that some level of loans and core deposits as well as some amount of liquid assets
determine the need for the bank to borrow or purchase funds.

12. A DI has $10 million in T-Bills, a $5 million line of credit to borrow in the repo market,
and $5 million in excess cash reserves (above reserve requirements) with the Fed. The DI
currently has borrowed $6 million in fed funds and $2 million from the Fed discount
window to meet seasonal demands.

a. What is the DIs total available (sources of) liquidity?

The DIs available resources for liquidity purposes are $10 + $5 + $5 = $20 million.

b. What is the DIs current total uses of liquidity?

The DIs current use of liquidity is $6 + $2 = $8 million.

c. What is the net liquidity of the DI?

The DIs net liquidity is $12 million.

205
d. What conclusions can you derive from the result?

The net liquidity of $12 million suggests that the DI can withstand unexpected withdrawals
of $12 million without having to reduce its less liquid assets at fire-sale prices.

13. A DI has the following assets in its portfolio: $20 million in cash reserves with the Fed,
$20 million in T-Bills, $50 million in mortgage loans, and $10 million in fixed assets. If the
assets need to be liquidated at short notice, the DI will receive only 99 percent of the fair
market value of the T-Bills and 90 percent of the fair market value of the mortgage loans.
Estimate the liquidity index using the above information.
n
I = i * i
w P where wi = weights of the portfolio,
i Pi
Pi = fire-sale prices,
Pi* = fair market value of assets

Thus, and assuming that fixed assets will not be disposed on short notice:

I = (20/100)(1.00/1.00) + (20/100)(0.99/1.00) + (50/100)(0.90/1.00) + (10/100)(1/1.00)


= 0.848

14. Conglomerate Corporation has acquired Acme Corporation. To help finance the takeover,
Conglomerate will liquidate the overfunded portion of Acmes pension fund. The face
values and current and one-year future liquidation values of the assets that will be
liquidated are given below:
Liquidation Values
Asset Face Value t=0 t=1
IBM stock $10,000 $9,900 $10,500
GE bonds $5,000 $4,000 $4,500
Treasury securities $15,000 $13,000 $14,000

Calculate the 1-year liquidity index for these securities.


n
I = i * i
w P
where wi = weights of the portfolio,
i Pi
Pi = fire-sale prices,
Pi* = fair market value of assets

Thus I = (0.333)(9900/10,500) + (0.167)(4,00/4,500) + (0.5)(13,000/14,000)


= 0.927

15. Plainbank has $10 million in cash and equivalents, $30 million in loans, and $15 in core
deposits.

a. Calculate the financing gap.

Financing gap = average loans average deposits = $30 million - $15 million = $15 million
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b. What is the financing requirement?

Financing requirement = financing gap + liquid assets = $15 million + $10 million = $25 m

c. How can the financing gap be used in the day-to-day liquidity management of the
bank?

A rising financing gap on a daily basis over a period of time may indicate future liquidity
problems due to increased deposit withdrawals and/or increased exercise of loan
commitments. Sophisticated lenders in the money markets may be concerned about these
trends, and they may react be imposing higher risk premiums for borrowed funds or stricter
credit limits on the amount of funds lent.

16. How can an FIs liquidity plan help reduce the effects of liquidity shortages? What are the
components of a liquidity plan?

A liquidity plan requires forward planning so that an optimal mix of funding can be implemented
to reduce costs and unforeseen withdrawals. In general, a plan could incorporate the following:

(a) Assigning a team that will take charge in the event of a liquidity crisis.

(b) Identifying the account holders that will most likely withdraw funds in the event of a crisis.

(c) Estimating the size of the run-offs and the sources of borrowing to stem the run-offs.

(d) Establishing maximum limits for borrowing by subsidiaries and affiliates, including inter-
affiliate loans, and the maximum risk premium to be paid during crisis borrowing.

(e) Specifying the sequencing of asset disposal in the event of a crisis.

Planning will ensure an orderly procedure to stem the rush of withdrawals and avert a total
breakdown during a crisis. This is very important for firms that rely on deposits or short-term
funds as a source of borrowing because of the difficulty in rolling over debt in periods of crisis.

17. What is a bank run? What are some possible withdrawal shocks that could initiate a bank
run? What feature of the demand deposit contract provides deposit withdrawal momentum
that can result in a bank run?

A bank run is an unexpected increase in deposit withdrawals from a bank. Bank runs can be
triggered by several economic events including (a) concerns about solvency relative to other
banks, (b) failure of related banks, and (c) sudden changes in investor preferences regarding the
holding of nonbank financial assets. The first come, first serve (full pay or no pay) nature of a
demand deposit contract encourages priority positions in any line for payment of deposit
accounts. Thus, even though money may not be needed, customers have incentive to withdraw
their funds.

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18. The following is the balance sheet of an DI in millions:

Assets Liabilities and Equity


Cash $ 2 Demand deposits $50
Loans $50
Plant and equipment $ 3 Equity $ 5
Total $55 Total $55

The asset-liability management committee has estimated that the loans, whose average
interest rate is 6 percent and whose average life is 3 years, will have to be discounted at 10
percent if they are to be sold in less than two days. If they can be sold in 4 days, they will
have to be discounted at 8 percent. If they can be sold later than a week, the DI will
receive the full market value. Loans are not amortized; that is, principal is paid at maturity.

a. What will be the price received by the DI for the loans if they have to be sold in two
days. In four days?

Price of loan = PVAn=3,k=10 (3) + PVn=3, k=10(50) = $45.03 if sold in two days.
Price of loan = PVAn=3,k=8 (3) + PVn=3, k=8(50) = $47.42 if sold in four days.

b. In a crisis, if depositors all demand payment on the first day, what amount will they
receive? What will they receive if they demand to be paid within the week? Assume no
deposit insurance.

If depositors demand to withdraw all their money on the first day, the bank will have to
dispose of its loans at fire-sale prices of $45.03 million. With its $2 million in cash, it will
be able to pay depositors on a first-come basis until $47.03 million has been withdrawn.
The rest will have to wait until liquidation to share the remaining proceeds.

Similarly, if the run takes place over a five-day period, the bank may have more time to
dispose of its assets. This could generate $47.42 millions. With its $2 million in cash it
would be able to satisfy on a first-come basis withdrawals up to $49.42 million.

19. What government safeguards are in place to reduce liquidity risk for DIs?

Deposit insurance and the discount window both help in the event of a liquidity drain and both
help to prevent liquidity drains from occurring.

20. What are the levels of defense against liquidity risk for a life insurance company? How
does liquidity risk for a property-casualty insurer differ from a life insurance company?

The initial defense is the amount of premium income and returns on the asset portfolio. As
additional policies are surrendered, the insurance company may need to sell some of the
relatively liquid assets such as government bonds. In the case of extreme liquidity pressures, the
company may need to begin to liquidate the less-liquid assets in the portfolio, possibly at
distressed prices.

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Property-casualty insurance covers short-term contingencies, and thus the assets of PC insurers
generally are more short-term than for life insurance companies, and the policy premium
adjustments come at shorter intervals. As a result, although the degree and timing of
contingency payout is more uncertain for PC companies, the flexibility to deal with liquidity
pressures is better.

21. How is the liquidity problem faced by mutual funds different from that faced by DIs and
insurance companies? How does the liquidity risk of an open-end mutual fund compare
with that of a closed-end fund?

In the case of a liquidity crisis in banks and insurance firms, there are incentives for depositors
and policyholders to withdraw their money or cash in their policies as early as possible.
Latecomers will be penalized because the financial institution may be out of liquid assets. They
will have to wait until the institution sells its assets at fire-sale prices, resulting in a lower payout.
In the case of mutual funds, the net asset value for all shareholders is lowered or raised as the
market value of assets change, so that everybody will receive the same price if they decide to
withdraw their funds. Hence, the incentive to engage in a run is minimized.

Closed-end funds are traded directly on stock exchanges, and therefore little liquidity risk exists
since any fund owner can sell the shares on the exchange. An open-end fund is exposed to more
risk since those shares are sold back to the fund which must provide cash to the seller.

22. A mutual fund has the following assets in its portfolio: $40 million in fixed-income
securities and $40 million in stocks at current market values. In the event of a liquidity
crisis, the fund can sell the assets at a 96 percent of market value if they are disposed of in
2 days. The fund will receive 98 percent if the assets are disposed of in 4 days. Two
shareholders, A and B, own 5 percent and 7 percent of equity (shares), respectively.

a. Market uncertainty has caused shareholders to sell the shares back to the fund. What
will the two shareholders receive if the mutual fund must sell all of the assets in two
days? In four days?

Value of fixed-income securities if sold in two days $40 x 0.96 = $38.4


Value of stocks if sold in two days $40 x 0.96 = $38.4
Total $76.8

Shareholder A will receive $76.8 x 0.05 = $3.84 down from the current value of $4.00.
Shareholder B will receive $76.8 x 0.07 = $5.376 down from the current value of $5.60.

Value of fixed-income securities if sold in four days $40 x 0.98 = $39.2


Value of stocks if sold in two days $40 x 0.98 = $39.2
Total $78.4

Shareholder A will receive $78.4 x 0.05 = $3.92 down from the current value of $4.00.
Shareholder B will receive $78.4 x 0.07 = $5.488 down from the current value of $5.60.

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b. How does this situation differ from a bank run? How have bank regulators mitigated
the problem of bank runs?

This differs from a run on a bank in that the claimants of the assets all receive the same
amount, as a percentage of their investments. In the case of bank runs, the first to withdraw
receives the full amount, leaving the likelihood that some depositors may not receive any
money at all. One way of mitigating this problem is for regulators to offer deposit
insurance such as that provided by the FDIC. This reduces the incentive to engage in runs.

23. A mutual fund has $1 million in cash and $9 million invested in securities. It currently has
1 million shares outstanding.

a. What is the net asset value (NAV) of this fund?

NAV = Market value of shares/number of shares = $10m/1m = $10 per share

b. Assume that some of the shareholders decide to cash in their shares of the fund. How
many shares at its current NAV can the fund take back without resorting to a sale of
assets? At the current NAV, it can absorb up to $1 million, or 100,000 shares.

c. As a result of anticipated heavy withdrawals, the fund sells 10,000 shares of IBM stock
currently valued at $40. Unfortunately, it receives only $35 per share. What is the net
asset value after the sale? What are the cash assets of the fund after the sale?

Its loss by selling 10,000 shares of IBM at $35 instead of $40 = -$5 x 10,000 = -$50,000.
New NAV = $9,950,000 /1m = $9.95
Cash = $1 million + $350,000 = $1.35 million and 9.60 million in securities.

d. Assume that after the sale of IBM shares, 100,000 shares are sold back to the fund.
What is the current NAV? Is there a need to sell more securities to meet this
redemption?

If 100,000 shares are redeemed, it needs to pay $9.95 x 100,000 = 995,000. Its NAV will
remain the same, i.e., $8,955,000/900,000 = $9.95. No, it does not need to sell any extra
shares since it has $1.35 million in cash.

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Chapter Eighteen
Liability and Liquidity Management
Chapter Outline

Introduction

Liquid Asset Management


Monetary Policy Implementation Reasons
Taxation Reasons

The Composition of the Liquid Asset Portfolio

Return-Risk Trade-Off for Liquid Assets


The Liquid Asset Reserve Management Problem for U.S. Depository Institutions
Undershooting/Overshooting of the Reserve Target

Liability Management
Funding Risk and Cost

Choice of Liability Structure


Demand Deposits
Interest-Bearing Checking (NOW) Accounts
Passbook Savings
Money Market Deposit Accounts (MMDAs)
Retail Time Deposits and CDs
Wholesale CDs
Federal Funds
Repurchase Agreements (RPs)
Other Borrowings

Liquidity and Liability Structures for U.S Depository Institutions

Liability and Liquidity Risk Management in Insurance Companies

Liability and Liquidity Risk Management in Other FIs

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter Eighteen

1. What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are
Treasury securities considered good examples of liquid assets?

A major benefit of an FI holding a large amount of liquid cash is that it can offset any
unexpected and large withdrawals without reverting to asset sales or emergency funding. If
assets have to be sold at short notice, FIs may not obtain a fair market value. It is more prudent to
anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid
assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is
high. FIs taking conservative positions by holding large amounts of liquid assets will therefore
have lower profits.

Treasury securities are considered good examples of liquid assets because they can be converted
into cash quickly with very little loss of value from current market levels.

2. How is an FIs liability and liquidity risk management problem related to the maturity of its
assets relative to its liabilities?

For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in
the average maturity between the assets and liabilities increases, liquidity risk increases. In the
event liabilities began to leave the FI or to be not reinvested by investors at maturity, the FI may
need to liquidate some of its assets at fire sale prices. These prices would tend to deviate farther
from the market value as the maturity of the assets increased. Thus the FI may sustain larger
losses.

3. Consider the assets (in millions) of two banks, A and B. Each bank is funded by $120
million in deposits and $20 million in equity. Which bank has the stronger liquidity
position? Which bank probably has a higher profit?

Bank A Asset Bank B Assets


Cash $10 Cash $20
Treasury securities $40 Consumer loans $30
Commercial loans $90 Commercial loans $90
Total Assets $140 Total Assets $140

Bank A is more liquid because it has more liquid assets than Bank B, although it has less cash.
Bank B probably earns a higher profit because the return on consumer loans should be greater
than the return on Treasury securities. However, comparing the loan portfolios is difficult
because it is impossible to evaluate the credit risk contained in each portfolio.

4. What concerns motivate regulators to require DIs to hold minimum amounts of liquid
assets?

Regulators prefer DIs to hold more liquid assets because this ensures that they are able to
withstand unexpected and sudden withdrawals. In addition, regulators are able to conduct

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monetary policy by influencing the money supply through liquid assets held by DIs. Finally,
reserves held at the Fed by financial institutions also are a source of funds to regulators, since
they do not pay interest on these deposits.

5. How do liquid asset reserve requirements enhance the implementation of monetary policy?
How are reserve requirements a tax on DIs?

In the case of banks and other lending institutions, reserve requirements on demand deposits
allow regulators to increase or decrease the money supply in an economy. The reserve
requirement against deposits limits the ability of banks to expand lending activity. Further,
reserves represent a form of tax that regulators can impose on DIs. By raising the reserve
requirements, regulators cause banks to transfer more balances into non-earning assets. This tax
effect is even larger in cases where inflation is stronger.

6. Rank these financial assets according to their liquidity: cash, corporate bonds, NYSE-
traded stocks, and T-bills.

The liquidity ranking from most liquid to least liquid would be cash, T-bills, NYSE-traded
stocks, and corporate bonds.

7. Define the reserve computation period, the reserve maintenance period, and the lagged
reserve accounting system.

The reserve computation period is a two-week period beginning on a Tuesday and ending on a
Monday over which the required reserves are calculated. The actual reserve calculation is
accomplished by multiplying the average deposit balance over this 14-day period times the
required reserve ratio. The exact amount of this reserve calculation is not known with certainty
until the end of the computation period.

The reserve maintenance period is the 14-day period over which the average level of reserves
must equal or exceed the required reserve target.

The lagged reserve accounting system occurs when the reserve maintenance period begins after
the reserve computation period is completed. As long as these two periods do not overlap, the FI
should have little uncertainty regarding the amount of reserves necessary to be in compliance
with regulatory guidelines.

8. City Bank has estimated that its average daily demand deposit balance over the recent 14-
day computation period was $225 million. The average daily balance with the Fed over the
14-day maintenance period was $11 million, and the average daily balance of vault cash
over the two-week computation period was $7 million.

a. Under the rules effective in 2004, what amount of average daily reserves is required to
be held during the reserve maintenance period for these demand deposit balances?

Reserve requirements = (0 x $6.0m) + ($42.1 - $6.0)(0.03) + ($225 - $42.1) (0.10)

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= 0 + $1.083 + $18.29 = $19.373 million

After subtracting the average daily balance of vault cash of $7 million, the bank needs to
maintain a daily average of $12.373 million ($19.373 million - $7 million) during the
maintenance period.

b. What is the average daily balance of reserves held by the bank over the maintenance
period? By what amount were the average reserves held higher or lower than the
required reserves?

The average daily balance over the maintenance period was $11 million. Therefore,
average reserves held were short $1.373 million.

c. If the bank had transferred $20 million of its deposits every Friday over the two-week
computation period to one of its off-shore facilities, what would be the revised average
daily reserve requirement?

For the 14-day period, the sum of its daily average is = $225 x 14 = $3,150. If $20 million
is transferred on Friday, the total reduction is $120 million over two weekends ($20 x 3
days x 2 weekends), and the total 14-day balance is $3,030. The average daily deposits will
be $216.4286 million.

Reserve requirements = (0 x $6.0m) + ($42.1 - $6.0)(0.03) + ($216.4286 - $42.1) (0.10)


= 0 + $1.083 + $17.4329 = $18.5159 million. City Bank needs to maintain average
reserves of $11.5159 million ($18.5159 million - $7 million) during the maintenance
period. Since it had $11 million of reserves, extra reserves of $0.5159 per day will need to
be set aside.

9. Assume that the 14-day reserve computation period for problem (8) above extended from
May 18 through May 31.

a. What is the corresponding reserve maintenance period under the rules effective in
2004?

The reserve maintenance period would extend from June 17 through June 30. The period
begins 30 days after the beginning of the reserve computation period. This makes it easier
for bank managers to meet their reserve requirements. By beginning two weeks and two
days after the end of the computation period, managers can more easily make up for any
errors in their forecast of reserve requirements.

b. Given your answers to parts (a) and (b) of problem (8), what would the average
required reserves need to be for the maintenance period for the bank to be in reserve
compliance?

The average required reserves necessary to be in compliance is $12.373 million.

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10. The average demand deposit balance of a local bank during the most recent reserve
computation period is $225 million. The amount of average daily reserves at the Fed
during the reserve maintenance period is $16 million, and the average daily vault cash
corresponding to the maintenance period is $4.3 million.

a. What is the average daily reserve balance required to be held by the bank during the
maintenance period?

Reserve requirements = (0 x $6.0m) + ($42.1 - $6.0)(0.03) + ($225 - $42.1) (0.10)


= 0 + $1.083 + $18.29 = $19.373 million

After subtracting the average daily balance of vault cash of $4.3 million, the bank needs to
maintain a target daily average of $15.073 million ($19.373 million - $4.3 million) during
the maintenance period.

b. Is the bank in compliance with the reserve requirements?

Yes. The bank has average reserves of $16 million. This amount exceeds the required
amount by $0.927 million.

c. What amount of reserves can be carried over to the next maintenance period, either as
excess or shortfall?

A maximum of 4 percent of the required reserves can be carried over to the next
maintenance period. Thus, 0.04 x $19.373 million = $0.7749 million can be carried over to
the next maintenance period.

d. If the local bank has an opportunity cost of 6 percent, what is the effect on the income
statement from this reserve period?

A total of $0.1521 million (0.927 0.7749) has an opportunity cost of no earnings at the 6
percent rate. Thus the loss would be $0.1521(0.06)(14/365) = $350.04.

11. The following demand deposits and cash reserves at the Fed have been documented by a
bank for computation of its reserve requirements (in millions) under two-day lagged
contemporaneous reserve accounting. The average vault cash for the computation period
has been estimated to be $2 million per day. (See the data on the following page.)

a. What level of average daily reserves is required to be held by the bank during the
maintenance period?

Average daily demand deposits = 300 + 250 + 280 + 260 + 260 + 260 + 280 + 300 + 270 +
260 + 250 + 250 + 250 + 240 = 3710/14 = 265

Reserve requirement = (6.0 - 0)(0) + (42.1 6.0)(0.03) + (265 42.1)(0.10)


= 0 + 1.083 + 22.29 = 23.373

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b. Is the bank in compliance with the requirements?
th
The maintenance period begins on Thursday (11 ) of the second month.
Average Reserves at Fed = 18 + 27 + 27 + 27 + 20 + 35 + 21 + 18 + 28 + 28 + 28 + 19 +
19 + 21 = 336/14 = 24.
Average reserves maintained = 24 + 2 = 26
Excess over required reserves = 26 - 23.373 = 2.627

Monday Tuesday Wednesday Thursday Friday


10th 11th 12th 13th 14th
Demand Deposits $200 $300 $250 $280 $260
Reserves at Fed $20 $22 $21 $18 $27

Monday Tuesday Wednesday Thursday Friday


17th 18th 19th 20th 21th
Demand Deposits $280 $300 $270 $260 $250
Reserves at Fed $20 $35 $21 $18 $28

Monday Tuesday Wednesday Thursday Friday


24th 25th 26th 27th 28th
Demand Deposits $240 $230 $250 $260 $270
Reserves at Fed $19 $19 $21 $19 $24

Monday Tuesday Wednesday Thursday Friday


New Month 1st 2nd 3rd 4th 5th
Demand Deposits $200 $300 $250 $280 $260
Reserves at Fed $20 $22 $21 $18 $27

8th 9th 10th 11th 12th


Demand Deposits $280 $300 $270 $260 $250
Reserves at Fed $20 $35 $21 $18 $27

Monday Tuesday Wednesday Thursday Friday


15th 16th 17th 18th 19th
Demand Deposits $240 $230 $250 $260 $270
Reserves at Fed $20 $35 $21 $18 $28

Monday Tuesday Wednesday Thursday Friday


22th 23th 24th 25th 26th
Demand Deposits $200 $300 $250 $280 $260
Reserves at Fed $19 $19 $21 $19 $24

c. What amount of required reserves can be carried over to the following computation
period?

Excess that can be carried over = 0.04 x $23.373 million = $0.9349 million.

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d. If the average cost of funds to the bank is 8 percent per year, what is the effect on the
income statement for this bank for this reserve period?

Loss = (2.627 - 0.9349 = 1.6921) x (0.08/365) * 14 = .005192 x 1,000,000= $5,192.20.

12. In July of 1998 the lagged reserve accounting (LRA) system replaced a contemporaneous
reserve accounting (CRA) system as the method of reserve calculation for DIs.

a. Contrast a contemporaneous reserve accounting (CRA) system with a lagged reserve


accounting (LRA) system.

Under LRA, the bank held reserves against the amount of deposits that had been in the
bank two weeks prior. The bank knew its required reserves on every day of the reserve
maintenance period. Since reserve requirements are stated in the form of average daily
balances, the bank could adjust its reserves over the maintenance period to exactly equal
the average reserve requirement. Moreover, under LRA the reserve maintenance and
calculation periods were one week while under CRA they are two weeks.

b. Under which accounting system, CRA or LRA, are DI reserves higher? Why?

Ceteris paribus, one would expect reserves to be higher under the CRA than under the
LRA, because under the LRA the bank knew its reserve requirement exactly on every day
of the reserve maintenance period. There was no need for the bank to hold excess reserves
as a cushion against an unforeseen increase in reserve requirements. Banks were able to
keep their reserves to the minimum required level. Under CRA, the bank does not know its
reserve requirement until the last two days of the reserve maintenance period. Since those
are the days during which Fed fund rates are most volatile, banks attempt to avoid large
reserve shortages late in the reserve maintenance period. They will therefore tend to hold
excess reserves early in the maintenance period that may be reduced on the last two days of
the settlement week.

c. Under which accounting system, CRA or LRA, is DI uncertainty higher? Why?

Since information was complete during the entire settlement week under LRA, but
complete under CRA only during the last two days of the maintenance period, there is more
uncertainty about reserve requirements under the CRA than under the LRA.

13. What is the weekend game? Contrast the DI's ability and incentive to play the weekend
game under LRA as opposed to CRA.

Since Friday balances are carried over the weekend and are counted for Saturday and
Sunday, they carry more weight in the reserve computations. Thus, the DIs developed a
strategy to send deposits off-shore on Friday, thereby reducing their Friday closing deposit
balances. When these deposits were bought back on Monday, average daily deposit
balances were reduced, thereby decreasing reserve requirements. Although the ratio of
weekends to total days in the reserve computation period is the same under LRA as under

217
CRA (2/7 or 4/14), there was greater flexibility for DIs to play the weekend game under
LRA. That is because the DI had complete information about reserve requirements on each
day of the maintenance period. However, because of the uncertainty under CRA, there is
greater incentive for DIs to play the weekend game under CRA than under LRA.

14. Under CRA, when is the uncertainty about the reserve requirement resolved? Discuss the
feasibility of making large reserve adjustments during this period of complete information.

Under CRA, the uncertainty regarding reserve requirements is resolved on the last two days
of the reserve maintenance period (on the last Tuesday and Wednesday of the 14 day
period). However, since these are also the days of greatest volatility in the Fed funds rate,
it could be very costly for the reserve manager to make large reserve adjustments or
corrections during this two-day period. Moreover, since the Fed funds market is comprised
of active traders that deal daily with one another, a large reserve imbalance would lead to
abnormal Fed funds transactions and would be quickly detected and exploited (to the
detriment of the original DI) by other DI traders.

15. What is the relationship between funding cost and funding or withdrawal risk?

Liabilities that have a low cost often have the highest risk of withdrawal. Thus a bank that
chooses to attract low cost deposits may have high withdrawal risk.

16. An FI has estimated the following annual costs for its demand deposits: management cost
per account = $140, average account size = $1,500, average number of checks processed
per account per month = 75, cost of clearing a check = $0.10, fees charged to customer per
check = $0.05, and average fee charged per customer per month = $8.

a. What is the implicit interest cost of demand deposits for the FI?

Cost of clearing checks = $0.10 x 75 x 12 = $90.00


Cost of managing each account = $140.00
Per check fee per account = $0.05 x 75 x 12 = -$45.00
Fee received per account = $8 x 12 = -$96.00
Total cost per account = $89.00

The average (imputed) interest cost of demand deposits = $89.00/1,500 = 5.93 percent.

b. If the FI has to keep an average of 8 percent of demand deposits as required reserves


with the Fed, what is the implicit interest cost of demand deposits for the FI?

If the bank has to keep 8 percent as reserves, its use of funds is limited to 0.92 x $1,500 per
account, or $1,380. The average (imputed) interest cost = $89/$1,380 = 6.45 percent.

c. What should be the check-clearing fees to reduce the implicit interest costs to 3
percent? Ignore the reserve requirements.

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For an average imputed interest cost of 3 percent, the total cost per account = 1,500 x 0.03
= $45. This means that the per-check fee should be increased to $89 from $45. Thus, the
fee per check should be raised to $89/(75 x 12) = $0.10 (actually $0.0989) per check.

17. A NOW account requires a minimum balance of $750 for interest to be earned at an annual
rate of 4 percent. An account holder has maintained an average balance of $500 for the first
six months and $1,000 for the remaining six months. She writes an average of 60 checks
per month and pays $0.02 per check, although it costs the bank $0.05 to clear a check.

a. What average return does the account holder earn on the account?

Gross interest return = Explicit interest return + Implicit interest return

Interest earned by account holder $1,000 x (0.04/2) = $20.00


Implicit fee earned on checks $0.03 x 60 x 12 = $21.60
Average deposit maintained during the year (500) + (1,000) = $750.00

Average interest earned = $41.60/750 = 5.55 percent

b. What is the average return if the bank lowers the minimum balance to $400?

If the minimum balance requirement is lowered to $400, the account holder earns an extra
$500 x (0.04/2) = $10 in interest. The average interest earned = $51.60/750 = 6.88 percent.

c. What is the average return if the bank pays interest only on the amount in excess of
$400? Assume that the minimum required balance is $400.

If the bank only pays interest on balances in excess of $400, the explicit interest earned =
$100 x 0.02 + $600 x 0.02 = $2 + $12 = $14. The implicit fee earned on checks = $21.60,
and the average interest earned = $35.60/$750 = 4.75%

d. How much should the bank increase its check-clearing fee to ensure that the average
interest it pays on this account is 5 percent? Assume that the minimum required balance
is $750.

Interest earned (both explicit and implicit) = $750 x 0.05 = $37.50. Fees to be earned
through check clearing = $37.50 - $20 = $17.50. Fee subsidy per check = 7.50/(60 x 12) =
$0.0243. So, the bank should charge $0.05 - $0.0243 = $0.0257 per check.

18. Rank order the following liabilities, with respect first to funding risk and then to funding
cost:
Funding Risk Funding Cost
a. Money market mutual funds.
b. Demand deposits. 12 1
c. Certificates of deposit. 8 5
d. Federal funds. 6 7

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e. Bankers acceptances. 4 9
f. Eurodollar deposits. 3 10
g. Money market demand deposits. 9 4
h. NOW accounts. 11 2
i. Wholesale CDs. 7 6
j. Passbook savings. 10 3
k. Repos. 5 8
l. Commercial paper. 2 11

The rankings above are not meant to be definitively precise, but are made to illustrate that the
funding cost and the funding risk are inversely related. For example, demand deposits usually
are considered to be the least-cost source of funding, but they also are easily withdrawn from the
bank. On the other hand, repos, wholesale CDs, and term fed funds are not liquid during their
term, but can be extremely liquid at maturity if the bank has any kind of financial distress. The
cost of each of these types of funds is directly linked to money market conditions. The contrast
between funding risk and funding cost for several of the liabilities is discussed below:

Demand deposits have low funding costs, but technically have high amounts of funding risk
since they can be withdrawn at any time. However, in practical terms, demand deposits are often
quite stable and may behave like long-term core deposits.

Certificates of deposit have high funding costs (because of reserve requirements and risk
premiums on negotiable CDs), but they have low funding risk since they can be withdrawn only
upon payment of interest penalties.

Federal funds have relatively low funding costs (although these costs are higher than those for
demand deposits) because of their overnight maturity, but they can have high funding risk if the
bank is distressed or not an active participant in the Fed funds market. However, for major
money center banks, the funding risk on Fed funds is quite low.

Eurodollar CD deposits have high funding costs because of the default risk premium, but they
are low funding risk. Eurodollar interbank deposits, however, are akin to demand deposits and
may have high funding risks, particularly if the bank is rumored to be in financial distress.

19. How is the withdrawal risk different for Federal funds and repurchase agreements?

Withdrawal risk is lower for repurchase agreements (RPs) because they are collateralized usually
by government securities. Since RPs are collateralized, they require a lower risk premium but
they require time to process because of the need to post collateral. In every other respect, the
transaction of an RP is similar to Federal funds.

20. How does the cash balance, or liquidity, of an FI determine the types of repurchase
agreement into which it will enter?

If the FI has surplus cash, it would buy securities with the understanding that the seller would
repurchase them later. In this case the repurchase agreement is an asset for the firm that bought

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the securities. If an FI is low on cash, it would sell securities for cash with the understanding
that it would repurchase the securities later. Here the repo is a liability.

21. How does the cost of MMMFs differ from the cost of MMDAs? How is the spread useful
in managing the withdrawal risk of MMDAs?

MMMFs earn rates of return that are directly related to the money market conditions for the
assets held by the funds. MMDAs can be priced to reflect these conditions, but they do not
necessarily need to be priced in this manner. Since the two products compete for investor funds,
banks can control the rate of withdrawal of funds from the MMDAs by raising or lowering the
explicit interest rate paid to depositors. Allowing the MMDA-MMMF spread to become
increasingly negative will increase the rate of withdrawal from the MMDA accounts.

22. Why do wholesale CDs have minimal withdrawal risk to the issuing bank?

Wholesale CDs are negotiable instruments that can be sold (discounted) in the secondary market.
Thus if the initial investor needs funds before the CDs mature, the CDs can be liquidated at
money market rates by the investor without withdrawing the funds from the issuing bank.

23. What characteristics of fed funds may constrain a DIs ability to use fed funds to expand
quickly its liquidity?

Fed funds are uncollateralized loans. As such, DIs selling fed funds often will limit the amount
of funds they will provide to any one borrowing institution. Further, fed funds do have risk of
non-rollover at maturity.

24. What does a low Fed funds rate indicate about the level of bank reserves? Why does the
Fed funds rate have higher than normal variability around the last two days in the reserve
maintenance period?

A low fed funds rate would indicate low levels of bank borrowing and an ample or at least
adequate supply of reserves among banks. Whether the general level of the fed funds rate is low
or high, the variability of the rate around the last two days in the reserve maintenance period will
accelerate as banks attempt to meet the required reserve levels.

25. What trends have been observed between 1960 and 2004 in regard to liquidity and liability
structures of commercial banks? What changes have occurred in the management of assets
that may cause the measured trends to be overstated?

From Table 18-4, it is clear that commercial banks have reduced their composition of liquid
assets to illiquid assets from 52 percent to 32 percent (liquid assets = cash; government and
agency securities; and other securities). However, this may be overstated because the illiquid
assets, such as commercial and mortgage loans, are significantly different today from prior years
because they can be securitized and sold in the secondary markets. As a result, they are not as
illiquid as they were in the past, which may be one reason why banks held more liquid assets in
prior years. Table 18-5 also shows that there has been a shift away from transaction accounts to

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time accounts, CDs, and borrowed funds. Although this reduces withdrawal risk, these funds are
more expensive for commercial banks.

26. What are two primary methods that insurance companies can use to reduce their exposure
to liquidity risk?

First, insurance companies can reduce their exposure by diversifying the distribution of risk in
the contracts they write. In addition, insurance companies can meet liquidity needs by holding
relatively marketable assets to cover claim payments.

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Chapter Nineteen
Deposit Insurance and Other Liability Guarantees
Chapter Outline

Introduction

Bank and Thrift Guaranty Funds


The FDIC

The Causes of the Depository Fund Insolvencies


The Financial Environment
Moral Hazard

Panic Prevention versus Moral Hazard

Controlling Depository Institution Risk Taking


Stockholder Discipline
Depositor Discipline
Regulatory Discipline

Non-U.S. Deposit Insurance Systems

The Discount Window


Deposit Insurance versus the Discount Window
The Discount Window

Other Guaranty Programs


National Credit Union Administration
Property-Casualty and Life Insurance Companies
The Securities Investor Protection Corporation
The Pension Benefit Guaranty Corporation

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter Nineteen

1. What is a contagious run? What are some of the potentially serious adverse social welfare
effects of a contagious run? Do all types of FIs face the same risk of contagious runs?

A contagious run is an unjustified panic condition in which liability holders withdraw funds from
a depository institution without first determining whether the institution is at risk. This action
usually occurs at a time that a similar run is occurring at a different institution that is at risk. The
contagious run may have an adverse effect on the level of savings that may affect wealth
transfers, the supply of credit, and control of the money supply. Depository institutions and
insurance companies face the most serious risk of contagious runs.

2. How does federal deposit insurance help mitigate the problem of bank runs. What other
elements of the safety net are available to banks in the U.S.?

Bank runs are costly to society since they create liquidity problems and can have a contagion
effect. Because of the first-come, first-serve nature of deposit liabilities, bank depositors have
incentives to run on the bank if they are concerned about the bank's solvency. As a result of the
external cost of bank runs on the safety and soundness of the entire banking system, the Federal
Reserve has put into place a safety net to remove the incentives to undertake bank runs. The
primary pieces of this safety net are deposit insurance and other guaranty programs that provide
assurance that funds are safe even in cases when the FI is in financial distress. Other elements of
the federal safety net are access to the lender of last resort (discount window borrowing), reserve
requirements, and minimum capital guidelines.

3. What major changes did the Financial Institutions Reform, Recovery, and Enforcement Act
of 1989 make to the FDIC and the FSLIC?

The FIRREA ACT of 1989 closed down the FSLIC, the agency that used to provide deposit
insurance to savings and loan associations (S&Ls). The responsibility of providing insurance to
the S&Ls was transferred to the FDIC, which manages it through a separate program, the
Savings and Insurance Fund.

4. Contrast the two views on, or reasons why, depository institution insurance funds became
insolvent in the 1980s.

One view is that insolvency can be explained by external events in the financial environment
such as the rise in interest rates and oil prices that took place in the early 1980s. The other view
is that deposit insurance brings about the types of behavior that lead to eventual insolvency. In
particular, deposit insurance contributes to the moral hazard problem whereby bank owners and
managers were induced to take on risky projects because the presence of deposit insurance
substantially reduced the adverse consequences to the depositors of such behavior.

5. What is moral hazard? How did the fixed-rate deposit insurance program of the FDIC
contribute to the moral hazard problem of the savings and loan industry? What other

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changes in the savings association environment during the 1980s encouraged the developing
instability of the industry?

Moral hazard occurs in the financial institution industry when the provision of deposit insurance
or other liability guarantees encourages the institution to accept asset risks that are greater than
the risks that would have been accepted without such liability insurance.

The fixed-rate deposit insurance administered by the FDIC created a moral hazard problem
because it did not differentiate between the activities of risky and conservative lending
institutions. Consequently, during periods of rising interest rates, S&Ls holding fixed-rate assets
were finding it increasingly difficult to obtain funds at lower rates. Since the deposits were
insured, managers found it easier to engage in risky ventures in order to offset the losses on their
fixed-rate loans. In addition, as the number of failures increased in the 1980s, regulators became
reluctant to close down banks because the fund was being slowly depleted. The combination of
excessive risk-taking together with a forbearance policy followed by the regulators led to the
S&L crisis.

6. How does a risk-based insurance program solve the moral hazard problem of excessive risk
taking by FIs? Is an actuarially fair premium for deposit insurance always consistent with a
competitive banking system?

A risk-based insurance program should deter banks from engaging in excessive risk-taking as
long as it is priced in an actuarially fair manner. Such pricing currently is being practiced by
insurance firms in the property-casualty sector. However, since the failure of commercial banks
can have significant social costs, regulators have a special responsibility towards maintaining
their solvency, even providing them with some form of subsidies. In a completely free market
system, it is possible that banks located in sparsely populated areas may have to pay extremely
high premiums to compensate for a lack of diversification or investment opportunities. Such
banks may have to close down unless subsidized by the regulators. Thus, a strictly risk-based
insurance system may not be compatible with a truly competitive banking system.

7. What are three suggested ways in which a deposit insurance contract could be structured to
reduce moral hazard behavior?

Deposit insurance contracts could be structured to reduce moral hazard behavior by (1)
increasing stockholder discipline, (2) increasing depositor discipline, and (3) increasing regulator
discipline.

8. What are some ways of imposing stockholder discipline to prevent them from engaging in
excessive risk taking?

Two ways of imposing stockholder discipline to prevent excessive risk taking are (a) through a
risk-based deposit insurance program, and (b) through increased capital requirements and
increased disclosure.
Risk-based deposit insurance premiums ensure that banks engaging in riskier activities will have
to pay higher premiums. One reason for the S&L crisis has been the fixed-rate deposit insurance

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premiums that did not differentiate between risky and conservative banks. As a result,
stockholders of FIs in financial difficulties had nothing to lose by investing in projects that had
high payoffs because depositors were protected by the FDIC insurance program.

Stockholder discipline also is increased if banks are required to hold more capital as well as
requiring more financial disclosures. The more capital a bank has, the less likely the failure of a
bank in the event of a decline in the market value of assets. This protects not only the depositors
but also the FDIC, which provides the insurance. Greater disclosure also allows regulators and
outside analysts to make more informed judgments on the viability of the institution, raising the
stock prices of better-managed FIs and lowering the stock prices of those that are excessively
risky.

9. How is the provision of deposit insurance by the FDIC similar to the FDIC writing a put
option on the assets of a DI that buys the insurance? What two factors drive the premium
of the option?

As long as the DI is profitable, the owners of the DI benefit by maintaining a positive market
value of equity. If the DIs performance falters sufficient that net worth becomes negative, the
owners can put the assets back to the FDIC who will pay off the insured depositors and sell the
assets. The premium on this put option, or deposit insurance, is positively related to the level of
risk of the assets and to the amount of leverage maintained by the DI.

10. What is capital forbearance? How does a policy of forbearance potentially increase the
costs of financial distress to the insurance fund as well as the stockholders?

Capital forbearance refers to regulators permitting an FI with depleted capital to continue


operations. The primary advantage occurs in the short run through the savings of liquidation
costs. In the longer run, the likely cost is that the poorly managed FI will become larger, more
risky, but no more solvent. Eventually even larger liquidation costs must be incurred.

11. Under what conditions may the implementation of minimum capital guidelines, either risk-
based or non-risk-based, fail to impose stockholder discipline as desired by the regulators?

Regulators must be willing to enforce immediately corrective action provisions against banks
that violate the minimum capital guidelines.

12. What four factors were provided by FDICIA as guidelines to assist the FDIC in the
establishment of risk-based deposit insurance premiums? What has happened to the level
of deposit insurance premiums since the risk-based program was implemented in 1993?
Why?

The FDIC must base deposit insurance premiums on (1) different categories and concentrations
of assets, (2) different categories and concentrations of liabilities, (3) other factors that affect the
probability of loss, and (4) the revenue needs of the insurer. In most cases the ranking of an
institution is based on regulators judgements regarding asset quality, loan underwriting
standards, and other operating risks. As the industry risk profile has improved and the revenue

226
needs of the FDIC insurance funds have decreased, the amount of the minimum risk premium
has fallen to zero for most banks.

13. Why did the fixed-rate deposit insurance system fail to induce insured and uninsured
depositors to impose discipline on risky banks in the United States in the 1980s?

The fixed-rate deposit insurance system understandably provided no incentives to depositors to


discipline the actions of banks since they were completely insured for deposits of up to $100,000
per account per bank. Uninsured depositors also had few incentives to monitor the activities of
banks because regulators had been reluctant to close down failing banks, especially larger banks.
This is because of the anticipated widespread social implications. As a result, both insured and
uninsured depositors were usually protected against bank losses, reducing the incentives to
monitor the actions of banks.

a. How is it possible to structure deposits in a DI to reduce the effects of the insured


ceiling?

Deposits are insured by the FDIC up to $100,000 per account per DI. Therefore, individual
depositors could expand coverage beyond $100,000 by placing deposits as joint accounts
and by having accounts in many DIs at the same time.

b. What are brokered deposits? Why are brokered deposits considered more risky than
non-brokered deposits by DI regulators?

Individuals and companies who wish to place more than $100,000 of deposits in DIs often
will hire brokers to place these deposits in blocks of $100,000 in DIs that pay the highest
interest rates. This activity is considered risky by the regulators for two reasons. First, the
DIs willing to pay the highest rates often have the highest need for deposits from a liquidity
standpoint. Second, when the deposits mature, the risk of withdrawal may force the DI to
pay even higher rates to keep the deposits. As a result, this higher cost of funds may force
the DI to engage in even riskier lending activities.

c. How did FIRREA and FDICIA change the treatment of brokered deposits from an
insurance perspective?

FIRREA specified that institutions that did not meet capital standards could not accept
brokered deposits and could not solicit deposits by paying interest rates that were
significantly higher than the prevailing market rates. FDICA further strengthened these
prohibitions by including any DIs that did not have risk-based capital of at least ten
percent.

d. What trade-offs were weighed in the decision to leave the deposit insurance ceiling at
$100,000?

Lowering the deposit insurance ceiling potentially would give depositors the incentive to
better monitor the risk of banks. However, such monitoring may also allow these

227
depositors to run from banks that became too risky. Such action would perhaps cause more
banks to fail that would put increased solvency pressure on the insurance fund.

14. What is the too-big-to-fail doctrine? What factors caused regulators to act in a way that
caused this doctrine to evolve?

Large banks were not allowed to fail because of the draining effects on the resources of the
insurance funds and the fear of contagious or systemic runs spreading to other large banks. Thus
the fear of significant negative effects on the financial system usually meant that both large and
small depositors in large banks were protected.

15. What failure resolution methods were available to regulators before the passage of FDICIA
in 1991? What was the essentiality provision?

Prior to FDICIA, the failure resolution methods included the payoff method, the purchase and
assumption method, and the open assistance method. The FDIC was forced to use liquidation
unless an alternative method cost less than liquidation to implement. Further, the FDIC could
choose to keep open a bank if the continued operation was considered essential to providing
financial services to the local community.

16. What procedural steps are involved under the payoff method of failure resolution?

The payoff method of failure resolution requires the FDIC to liquidate the assets and to pay off
the insured depositors in full or to transfer the deposits to another local bank. Uninsured
depositors and the FDIC have pro rata claims on the remaining value of the banks assets.

17. How was the FDICs potential liability reduced by the 1993 depositor protection
legislation? How does this method of failure resolution encourage uninsured depositors to
monitor more closely the DIs risk taking?

Under the 1993 legislation, the FDIC and the domestic uninsured depositors were given priority
over foreign uninsured depositors and creditors supplying fed funds. Because uninsured
depositors probably will share in the net loss of the DI upon liquidation, it is in their interest to
monitor carefully the risk position of the DI on an ongoing basis.

18. What are the three types of purchase and assumption failure resolution?

The three types of P&A failure resolution are (1) total bank, (2) insured deposits only, and (3)
clean P&A.

a. How does the clean P&A differ from the total bank P&A?

Under a clean P&A the good assets and all deposits of a failed institution are assumed by
another bank. The difference between the total value of the deposits (larger) and the value
of the good assets (smaller) is paid in a cash infusion by the FDIC. Under the total bank
P&A, all assets are transferred to the assuming bank with the option that the bank could put

228
back to the FDIC at a later date those assets that were identified to be questionable from a
credit perspective. This method required a smaller cash infusion by the FDIC at the time of
the assumption.

b. How are the uninsured depositors treated differently in a clean P&A as opposed to the
payoff method of failure resolution?

The clean P&A treats large, uninsured depositors as de facto insured depositors. That is,
the depositors do not face the risk of loss. Under the payoff method, the uninsured
depositors share in the net worth loss with the FDIC.

c. How does the open assistance process solidify the too-big-to-fail guaranty?

The open assistance policy provides funds to keep open a large failing DI while a
restructuring plan is designed and implemented. Uninsured depositors at other large DIs
interpret this policy to be that all large DIs will not be allowed to fail, thus removing the
incentive of these depositors to monitor the risk of the DIs.

19. What are some of the essential features of the FDICIA of 1991 with regard to the resolution
of failing DIs?

The FDICIA of 1991 has made it very difficult for regulators to delay the closing of failing DIs
unless the danger of a systemic risk can be shown. They are expected to use the least cost
resolution (LCR) strategy to close down DIs, and shareholders and uninsured depositors are
expected to bear the brunt of the loss. Unlike in prior years, the FDIC will only subsidize if the
liquidated assets are not sufficient to cover the insured deposits. The General Accounting Office
has also been authorized to audit failure resolutions used by regulators to ensure that the least
cost strategy has been adopted.

a. What is the least-cost resolution (LCR) strategy?

The LCR requires the cost of each failure resolution alternative to be evaluated on a present
value basis.

b. When can the systemic risk exemption be used as an exception to the LCR policy of
bank closure methods?

The systemic risk exemption can be used only when it can be shown that the closure of a
large DI will cause a significant threat to the entire financial system.

c. What procedural steps must be taken for the approval of using the systemic risk
exemption?

Use of the systemic risk exemption requires the approval of two thirds of the Federal
Reserve Board members and the FDIC board as well as the recommendation of the
Secretary of Treasury and the President of the United States.

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d. What are the implications to the other DIs in the economy of the implementation of this
exemption?

The net cost of the bailout of a large DI will be shared by all other DIs by charging them an
additional deposit insurance premium based on their size as measured by domestic and
foreign deposits and borrowed funds.

20. What is the primary goal of the FDIC when employing the LCR strategy?

The purpose for implementing this strategy was to pass more of the failure resolution cost to
uninsured depositors.

a. How is the insured depositor transfer method implemented in the process of failure
resolution?

Upon failure the good assets and the insured deposits are transferred to a takeover DI. In
addition an amount of uninsured deposits equal to the remaining amount of uncovered good
asset also are transferred to the assuming DI. Uninsured depositors lose a portion of their
deposits based on the difference between the estimated value of the assets and the amount
of insured deposits in the DI.

b. Why does this method of failure resolution encourage uninsured depositors to more
closely monitor the strategies of DI managers?

Because uninsured depositors assume all of the losses, they have a much stronger incentive
to monitor and control the actions of DI owners.

21. The following is a balance sheet of a commercial bank (in millions of dollars).

Assets Liabilities and Equity


Cash $5 Insured Deposits $30
Loans $40 Uninsured Deposits $10
Equity $5
Total Assets $45 Total Liabilities & Equity $45

The bank experiences a run on its deposits after it declares it will write off $10 million of
its loans as a result of nonpayment. The bank has the option of meeting the withdrawals by
first drawing down its cash and then by selling off its loans. A fire sale of loans in one day
can be accomplished at a 10 percent discount. They can be sold at a 5 percent discount if
sold in two days. The full market value will be obtained if they are sold after two days.

a. What is the amount of loss to the insured depositors if a run on the bank occurs on the
first day? On the second day?

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Insured depositors will not lose any money because even if the bank does not make the
payment, they will be paid by the FDIC. Specifically, the value of the loans on the first day
is 0.90 x $30 = $27m and their value on the second day is 0.95 x $30 = $28.5m. With its
cash reserves, it has a more than adequate amount to pay the insured depositors as long as
the uninsured depositors are not given the opportunity to cash in their deposits first.

b. What amount do the uninsured depositors lose if the FDIC uses the insured depositor
transfer method to close the bank immediately? The assets will be sold after the two-
day period.

Based on book value, the uninsured depositors will receive $5 million out of their $10
million, and thus they will lose only $5 million. However, based on the present value of
the loans, the uninsured depositors will lose $6.5 million since only $3.5 million is
available for distribution. The equity holders will lose all of their capital.

22. A bank with insured deposits of $55 million and uninsured deposits of $45 million has
assets valued at only $75 million. What is the cost of failure resolution to insured
depositors, uninsured depositors, and the FDIC if the following occur?

a. The payoff method is used.

Insured depositors are fully paid by the FDIC and bear no loss. The FDIC receives $41.25
million ($75 million x 0.55) from the liquidation of the assets and bears a loss of ($55 -
$41.25) = $13.75 million. Uninsured depositors receive $33.75 million against their
liabilities of $45 million, for a loss of $11.25 million.

b. A purchase and assumption is arranged with no purchase premium.

Uninsured depositors are fully paid by the FDIC and bear no loss. Insured depositor
liabilities are fully transferred to the acquiring bank and therefore they bear no loss. The
FDIC bears the entire loss of $25 million ($55 + $45 - $75).

c. A purchase and assumption is arranged with a $5 million purchase premium.

Neither uninsured nor insured depositors lose. The cost to the FDIC is reduced by the
purchase premium of $5 million. Since the FDIC only injects $20 million into the merged
institution, the loss to the FDIC is $20 million.

d. A purchase and assumption is arranged with a $25 million purchase premium.

There is no loss to any claimant. The purchase premium is just equal to the negative net
worth of the acquired bank.

e. An insured depositor transfer method is used.

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Neither the insured depositors nor the FDIC lose under the insured depositor transfer
method. Uninsured depositors receive the remaining bank assets of $75m - $55m = $20
million against liabilities of $45 million, for a loss of $25 million.

23. A commercial bank has $150 million in assets at book value. The insured and uninsured
deposits are valued at $75 and $50 million, respectively, and the book value of equity is
$25 million. As a result of loan defaults, the market value of the assets has decreased to
$120 million. What is the cost of failure resolution to insured depositors, uninsured
depositors, shareholders and the FDIC if the following occur?

a. A payoff method is used to close the bank.

Under the payoff method, the loss of $30 million will be borne mainly by shareholders,
whose $25 million net worth will all be lost. The remaining $5 million loss will be borne
by the FDIC and the uninsured depositors on a pro-rata basis. This is because after the $75
million is paid to the insured depositors, the assets will be divided between the FDIC and
the uninsured depositors on a pro-rata basis. The FDIC will receive $72 million (and lose
$3 million) and the uninsured depositors will receive $48 million (and lose $2 million).

b. A purchase and assumption method with no purchase premium paid is used.

Under the purchase and assumption method, the loss of $25 million will be borne by
shareholders and the remaining $5 million by the FDIC.

c. A purchase and assumption method is used with $10 million paid as a purchase
premium.

Under this method with a $10 million purchase premium, no loss is incurred by the insured
depositors, uninsured depositors, or the FDIC. Shareholders will lose only $20 million.

d. An insured depositor transfer method is used.

Under the insured depositor transfer method, all losses will be borne by shareholders,
followed by uninsured depositors, before the FDIC takes any loss. Thus, in this example,
shareholders will lose $25 million and the uninsured depositors will lose $5 million.

24. In what ways did FDICIA enhance the regulatory discipline to help reduce moral hazard
behavior? What has been the operational impact of these directives?

FDICIA approached the moral hazard problem in the separate areas of examinations and capital
forbearance. In the area of examinations, FDICIA (1) required improved accounting standards
that focused on market valuation, (2) required annual on-site examination of every bank, and (3)
allowed private accountants a greater role in the auditing of banks. FDICIA also clarified
immediacy and degree of actions in cases where bank capital fell into different rating zones. The
effect of these policies is to reduce discretion in the treatment of banks that have financial
distress.

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25. Match the following policies with their intended consequences:

Policies:
a. Lower FDIC insurance levels
b. Stricter reporting standards
c. Risk-based deposit insurance

Consequences:
1. Increased stockholder discipline
2. Increased depositor discipline
3, Increased regulator discipline

Answer: a-2, b-3, c-1

26. Why is access to the discount window of the Fed less of a deterrent for bank runs than
deposit insurance?

Although banks have access to the deposit window in the event of bank runs, this is less effective
than deposit insurance because:

a. Banks have to put up collateral in order to borrow from the discount window, and collateral
may not be available during bank runs.

b. Access is by no means guaranteed. Loans may be denied by the Fed if it is clear that the
bank is insolvent.

c. FDICIA of 1991 has limited the Feds ability to lend to undercapitalized banks to only 60
days in any 120-day period. Extensions require approval by both the FDIC and the primary
regulator of the bank to certify that the bank is viable.

d. If the bank ultimately fails, the Fed will have to compensate the FDIC for incremental
losses.

27. How do insurance guaranty funds differ from deposit insurance? What impact do these
differences have on the incentive for insurance policyholders to engage in a contagious run
on an insurance company?

Insurance companies are regulated at the state level. As such, the state guaranty fund programs
are administered by the private insurance companies. Further, there is no permanent guaranty
reserve fund for the entire industry, and the amount of the required contributions required of
surviving insurers to protect policyholders varies widely across the different states. Finally,
small policyholders often must wait for an extended period of time before receiving benefits
from the guaranty funds. As a result of these reasonable inefficiencies, the incentive for
insurance policyholders to engage in a run on the companies is quite strong as compared to the
banking industry.

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28. What was the purpose of the establishment of the Pension Benefit Guaranty Corporation
(PBGC)?

PBGC was established to protect pension benefits from the underfunding of pension plans by
corporations.

a. How does the PBGC differ from the FDIC in its ability to control risk?

First, the premium is based on the number of participants, not on the amount of pension
contributions or benefits covered. Recently, a variable-rate premium has been applied to
those plans that are underfunded. Further, the PBGC has no monitoring power and thus
cannot restrict the risk-taking of plan managers in the administration of the portfolios.

b. How is the 1994 Retirement Protection Act expected to reduce the deficits currently
experienced by the Pension Benefit Guaranty Corporation (PBGC)?

Although the PBGC has no way of monitoring the pension fund it insures, it has been
charging $19 per participant for funded plans and $72 for unfunded plans, the maximum
allowed by law. The 1994 law phased out this ceiling by 1997 so that unfunded plans could
pay more in premiums. This will allow an effective risk-based premium system.

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Chapter Twenty
Capital Adequacy
Solutions for End-of-Chapter Questions and Problems: Chapter Twenty

1. Identify and briefly discuss the importance of the four functions of an FIs capital?

Capital serves as a primary cushion against operating losses and unexpected losses in the value
of assets (such as the failure of a loan). FIs need to hold enough capital to provide confidence to
uninsured creditors that they can withstand reasonable shocks to the value of their assets. In
addition, the FDIC, which guarantees deposits, is concerned that sufficient capital is held so that
their funds are protected, because they are responsible for paying insured depositors in the event
of a failure. Finally, capital also serves as a source of financing to purchase and invest in assets.

2. Why are regulators concerned with the levels of capital held by an FI compared to a non-
financial institution?

Regulators are concerned with the levels of capital held by an FI because of its special role in
society. A failure of an FI can have severe repercussions to the local or national economy unlike
non-financial institutions. Such externalities impose a burden on regulators to ensure that these
failures do not impose major negative externalities on the economy. Higher capital levels will
reduce the probability of such failures.

3. What is the P/E ratio? How do the three performance variables affect the P/E ratio
according to the dividend growth model?

The P/E ratio measures the price per share of earnings that investors are willing to pay for a share
of stock.. The ratio will be higher as (1) the dividend payout ratio is higher, (2) the growth rate
in dividends is higher, and (3) the firms cost (required return) of equity is lower.

4. Peoples Bank has reported net income of $3.60 per share for the most recent year. The
banks dividend-payout ratio is 30 percent, the growth in dividends is 7.5 percent, and the
required return by shareholders is 10 percent.

a. What is the year-end price of the stock?

The dividend at year-end (D0) is $3.60 x 0.30 = $1.08. According to the dividend growth
model, the year-end stock price is $1.08(1.075)/(0.10 0.075) = $46.44.

b. What is the year-end price/earnings ratio?

The year-end price/earnings ratio is $46.44/$3.60 = 12.90x.

1
c. What is the year-end price/earnings ratio for each of the following incremental changes
in the above assumptions?

1. The growth rate is 9 percent.

D 1 = $1.08 x 1.09 = $1.1772. P0 = $1.1772/(0.10 0.09) = $117.72. P/E = 32.7x.

2. The dividend payout rate is 40 percent.

D 0 = $3.60(0.40) = $1.44. D1 = $1.44(1.075) = $1.548. P0 = $1.548/(0.100.075) = $61.92.


P/E = $61.92/$3.60 = 17.2x.

3. The required return on equity is 9 percent.

D 1 = $1.08 x 1.075 = $1.161. P0 = $1.161/(0.09 0.075) = $77.40. P/E = 21.5x.

d. What is the year-end price/earnings ratio if all three assumptions are changed?

D1 = $1.44 x 1.09 = $1.5696. P 0 = $1.5696/(0.09 0.09) = infinity. Clearly the price


would be very high. If the required return is 10 percent, the price would be $156.96, and
P/E = 43.6x. If the required return is 9.5 percent, the price would be $313.92, and P/E =
87.2x. If the required return is 9.10 percent, the price would be $1,569.60, and P/E = 436x.

5. What are the differences between the economic definition of capital and the book value
definition of capital?

The book value definition of capital is the value of assets minus liabilities as found on the
balance sheet. This amount often is referred to as accounting net worth. The economic
definition of capital is the difference between the market value of assets and the market value of
liabilities.

a. How does economic value accounting recognize the adverse effects of credit and
interest rate risk?

The loss in value caused by credit risk and interest rate risk is borne first by the equity
holders, and then by the liability holders. In market value accounting, the adjustments to
equity value are made simultaneously as the losses due to these risk elements occur. Thus
economic insolvency may be revealed before accounting value insolvency occurs.

b. How does book value accounting recognize the adverse effects of credit and interest
rate risk?

Because book value accounting recognizes the value of assets and liabilities at the time
they were placed on the books or incurred by the firm, losses are not recognized until the
assets are sold or regulatory requirements force the firm to make balance sheet accounting

2
adjustments. In the case of credit risk, these adjustments usually occur after all attempts to
collect or restructure the loans have occurred. In the case of interest rate risk, the change in
interest rates will not affect the recognized accounting value of the assets or the liabilities.
6. A financial intermediary has the following balance sheet (in millions) with all assets and
liabilities in market values:

Assets Liabilities and Equity


6 percent semi-annual 4-year 5 percent 2-year subordinated debt
Treasury-notes (par value $12) $10 (par value $25) $20
7 percent annual 3-yr.
AA-rated bonds (par=$15) $15
9 percent annual 5-yr
BBB rated bonds (par=$15) $15 Equity capital $20
Total Assets $40 Total Liabilities & Equity $40

a. Under FASB Statement No. 115, what would be the effect on equity capital (net worth)
if interest rates increase by 30 basis points? The T-notes are held for trading purposes,
the rest are all classified as held to maturity.

Only assets that are classified for trading purposes or available-for-sale are to be reported at
market values. Those classified as held-to-maturity are reported at book values. The
change in value of the T-notes for a 30 basis points change in interest rates is:

$10 = PVAn=8,k=?($0.36) + PV n=8,k=?($12) k = 5.6465 x 2 = 11.293%


If k =11.293% + 0.30% =11.593/2 = 5.7965%, the value of the notes will decline to:
PVAn=8,k=5.7965($0.36) + PVn=3,k=5.7965($12) = $9.8992. And the change in value is $9.8992 -
$10 = -0.1008 x $1,000,000 = $100,770.39

The remainder of the balance sheet remains the same:


6% semi-annual 4-year 5% 2-year subordinated debt
T-notes (par value $12) $9.8992 (par value $25) $20.0000
7% annual 3-yr.
AA-rated bonds (par=$15) $15.0000 Equity capital $20.0000
9% annual 5-yr
BBB rated bonds (par=$15) $15.0000 Adj. To equity -0.1008
Total $39.8992 $39.8992

b. Under FASB Statement No. 115, how are the changes in the market value of assets
adjusted in the income statements and balance sheets of FIs?

Under FASB Statement No. 115 assets held till maturity will be kept in book value. Assets
available for sale and for trading purposes will always be reported in market values except
by securities firms, which will have all assets and liabilities reported in market values.
Also, all unrealized and realized income gains and losses will be reflected in both income

3
statements and balance sheets for trading purposes. Adjustments to assets available for sale
will be reflected only through equity adjustments.

7. Why is the market value of equity a better measure of a bank's ability to absorb losses than
book value of equity?

The market value of equity is more relevant than book value because in the event of a
bankruptcy, the liquidation (market) values will determine the FI's ability to pay the various
claimants.

8. State Bank has the following year-end balance sheet (in millions):

Assets Liabilities and Equity


Cash $10 Deposits $90
Loans $90 Equity $10
Total Assets $100 Total Liabilities & Equity$100

The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-
term or variable-rate. Rising interest rates have caused the failure of a key industrial
company, and as a result, three percent of the loans are considered to be uncollectable and
thus have no economic value. One-third of these uncollectable loans will be charged off.
Further, the increase in interest rates has caused a 5 percent decrease in the market value of
the remaining loans. What is the impact on the balance sheet after the necessary
adjustments are made according to?

a. Book value accounting.

Under book value accounting, the only adjustment is to charge off 1 percent of the loans.
Thus the loan portfolio will decrease by $0.90 and a corresponding adjustment will occur in
the equity account. The new book value of equity will be $9.10. We assume no tax affects
since the tax rate is not given.

b. Market value accounting.

Under market value accounting, the 3 percent decrease in loan value will be recognized, as
will the 5 percent decrease in market value of the remaining loans. Thus equity will
decrease by 0.03 x $90 + 0.05 x $90(1 0.03) = $7.065. The new market value of equity
will be $2.935.

c. What is the new market to book value ratio if State Bank has $1 million shares
outstanding?

The new market to book value ratio is $2.935/$9.10 = 0.3225.

9. What are the arguments for and against the use of market value accounting for FIs?

4
Market values produce a more accurate picture of the banks current financial position for both
stockholders and regulators. Stockholders can more easily see the effects of changes in interest
rates on the banks equity, and they can evaluate more clearly the liquidation value of a
distressed bank. Among the arguments against market value accounting are that market values
sometimes are difficult to estimate, particularly for small banks with non-traded assets. This
argument is countered by the increasing use of asset securitization as a means to determine value
of even little-traded assets. In addition, some argue that market value accounting can produce
higher volatility in the earnings of banks. A significant issue in this regard is that regulators may
close a bank too quickly under the prompt corrective action requirements of FDICIA.

10. How is the leverage ratio for a bank defined?

The leverage ratio is ratio of book value of core capital to total assets, where core capital is book
value of equity plus qualifying cumulative perpetual preferred stock plus minority interests in
equity accounts of consolidated subsidiaries.

11. What is the significance of prompt corrective action as specified by the FDICIA
legislation?

The prompt corrective action provision requires regulators to appoint a receiver for the bank
when the leverage ratio falls below 2 percent. Thus even though the bank is technically not
insolvent in terms of book value of equity, the institution can be placed into receivorship.

12. Identify and discuss the weaknesses of the leverage ratio as a measure of capital adequacy.

First, closing the a bank when the leverage ratio falls below 2 percent does not guarantee that the
depositors are adequately protected. In many cases of financial distress, the actual market value
of equity is significantly negative by the time the leverage ratio reaches 2 percent. Second, using
total assets as the denominator does not consider the different credit and interest rate risks of the
individual assets. Third, the ratio does not capture the contingent risk of the off-balance sheet
activities of the bank.

13. What is the Basle Agreement?

The Basle Agreement identifies the risk-based capital ratios agreed upon by the member
countries of the Bank for International Settlements. The ratios are to be implemented for all
commercial banks under their jurisdiction. Further, most countries in the world now have
accepted the guidelines of this agreement for measuring capital adequacy.

14. What is the major feature in the estimation of credit risk under the 1988 Basle capital
requirements?

The major feature of the Basle Agreement is that the capital of banks must be measured as an
average of credit-risk-adjusted total assets both on and off the balance sheet.

5
15. What is the total risk-based capital ratio?

The total risk-based capital ratio divides total capital by the total of risk-adjusted assets. This
ratio must be at least 8 percent for a bank to be considered adequately capitalized. Further, at
least 4 percent of the risk-based assets must be supported by core capital.

16. Identify the five zones of capital adequacy and explain the mandatory regulatory actions
corresponding to each zone.

Zone 1: Well capitalized. The total risk-based capital ratio (RBC) ratio exceeds 10 percent. No
regulatory action is required.

Zone 2: Adequately capitalized. The RBC ratio exceeds 8 percent, but is less than 10 percent.
Institutions may not use brokered deposits except with the permission of the FDIC.

Zone 3: Undercapitalized. The RBC ratio exceeds 6 percent, but is less than 8 percent.
Requires a capital restoration plan, restricts asset growth, requires approval for
acquisitions, branchings, and new activities, disallows the use of brokered deposits, and
suspends dividends and management fees.

Zone 4: Significantly undercapitalized. The RBC ratio exceeds 2 percent, but is less than 6
percent. Same as zone 3 plus recapitalization is mandatory, places restrictions on
deposit interest rates, interaffiliate transactions, and the pay level of officers.

Zone 5: Critically undercapitalized. The RBC ratio is less than 2 percent. Places the bank in
receivorship within 90 days, suspends payment on subordinated debt, and restricts other
activities at the discretion of the regulator.

The mandatory provisions for each of the zones described above include the penalties for any of
the zones prior to the specific zone.

17. What are the definitional differences between Tier I and Tier II capital?

Tier I capital is comprised of the most junior (subordinated) securities issued by the firm. These
include equity and qualifying perpetual preferred stock. Tier II capital is senior to Tier I, but
subordinated to deposits and the deposit insurer's claims. These include preferred stock with
fixed maturities and long term debt with minimum maturities over 5 years. Tier II capital often is
called supplementary or secondary capital.

18. What components are used in the calculation of risk-adjusted assets?

The two components are risk-adjusted on-balance-sheet assets and risk-adjusted off-balance-
sheet assets.

6
19. Explain the process of calculating risk-adjusted on-balance sheet assets.

Balance sheet assets are assigned to four categories of credit risk exposure. The dollar amount of
assets in each category is multiplied by an appropriate weight of 0 percent, 20 percent, 50
percent, and 100 percent respectively for the categories representing no risk to full credit risk
respectively. The weighted dollar amounts of each category are added together to get the total
risk-adjusted on-balance-sheet assets.

a. What assets are included in the four categories of credit risk exposure?

Category 1 includes cash, United States Treasury bills, notes and bonds, mortgage backed
securities, and Federal Reserve Bank balances. Category 2 includes U.S. agency-backed
securities, municipal issued general obligation bonds, FHLMC and FNMA mortgage-
backed securities, and interbank deposits. Category 3 includes other municipal revenue
bonds and regular residential mortgage loans. All other commercial, consumer, and credit
card loans, real assets and any other asset not included above are included in category 4.

b. What are the appropriate risk-weights for each category?

Category 1 has a risk weight of 0 percent, category 2 has a risk weight of 20 percent,
category 3 has a risk weight of 50 percent, and category 4 has a risk weight of 100 percent.

20. National Bank has the following balance sheet (in millions) and has no off-balance-sheet
activities:

Assets Liabilities and Equity


Cash $20 Deposits $980
Treasury bills $40 Subordinated debentures $40
Residential mortgages $600 Common stock $40
Other loans $430 Retained earnings $30
Total Assets $1,090 Total Liabilities and Equity $1,090

a. What is the leverage ratio?

The leverage ratio is ($40 + $30)/$1,090 = 0.06422 or 6.422 percent.

b. What is the Tier I capital ratio?

Risk-adjusted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730.


Tier I capital ratio = ($40 + $30)/$730 = 0.09589 or 9.59 percent.

c. What is the total risk-based capital ratio?

The total risk-based capital ratio = ($40 + $40 + $30)/$730 = 0.150685 or 15.07 percent.

7
d. In what capital category would the bank be placed?

The bank would be place in the well-capitalized category.

21. Onshore Bank has $20 million in assets, with risk-adjusted assets of $10 million. Tier I
capital is $500,000, and Tier II capital is $400,000. How will each of the following
transactions affect the value of the Tier I and total capital ratios? What will be the new
value of each ratio?

The current value of the Tier I ratio is 0.05 and the total ratio is 0.09.

a. The bank repurchases $100,000 of common stock.

Tier I decreases to 0.04, and the total ratio decreases to 0.08.

b. The bank issues $2,000,000 of CDs and uses the proceeds for loans to homeowners.

Tier I decreases to $500,000/$11 million = 0.0454, and the total ratio decreases to 0.0818.

c. The bank receives $500,000 in deposits and invests them in T-bills.

Both ratios remain unchanged.

d. The bank issues $800,000 in common stock and lends it to help finance a new shopping
mall.

Tier I increases to $1.3/$10.8 = 0.1204, and the total ratio increases to 0.1574.

e. The bank issues $1,000,000 in nonqualifying perpetual preferred stock and purchases
general obligation municipal bonds.

Tier I decreases to $500,000/$10.2 million = 0.0490, and the total ratio decreases to 0.0882.

f. Homeowners pay back $4,000,000 of mortgages, and the bank uses the proceeds to
build new ATMs.

Tier I decreases to $500,000/$12 million = 0.041667, and the total ratio decreases to 0.075.

22. Explain the process of calculating risk-adjusted off-balance-sheet contingent guaranty


contracts?

The first step is to convert the off-balance-sheet items to credit equivalent amounts of an on-
balance-sheet item by multiplying the notional amounts by an appropriate conversion factor as
given in Table 20-12. The converted amounts then are multiplied by the appropriate risk weights
as if they were on-balance-sheet items.

8
a. What is the basis for differentiating the credit equivalent amounts of contingent
guaranty contracts?

The factors used in the conversion are arbitrary selections from the list of choices approved
by the regulators. While a subjective relationship undoubtedly exists between the factors
and the respective credit risks to the bank, no theoretical valuation models were utilized to
determine the specific weights that are used.

b. On what basis are the risk weights for the credit equivalent amounts differentiated?

The appropriate risk weights depend on the counterparty source to off-balance-sheet


activity.

23. Explain how off-balance-sheet market contracts, or derivative instruments, differ from
contingent guaranty contracts?

Off-balance-sheet contingent guaranty contracts in effect are forms of insurance that banks sell
to assist customers in the financial management of the customers businesses. Market contracts,
or derivative instruments, typically are used by bank management to assist in the management of
the banks assets and liability risks. For example, a loan commitment or a standby letter of credit
may be provided to help a customer with another source of financing, while an over-the-counter
interest rate swap likely would be used by the bank to help manage interest rate risk.

a. What is counterparty credit risk?

Counterparty credit risk is the risk that the other party in a contract may default on their
payment obligations.

b. Why do exchange-traded derivative security contracts have no capital requirements?

Counterparty obligations of exchange-traded contracts are guaranteed by the exchange on


which they are traded. Thus there is no counterparty risk to the bank.

c. What is the difference between the potential exposure and the current exposure of over-
the-counter derivative contracts?

The potential exposure is the portion of the credit equivalent amount that would be at risk if
the counterparty to the contract defaulted in the future. The current exposure is the cost of
replacing the contract if the counterparty defaulted today.

d. Why are the credit conversion factors for the potential exposure of foreign exchange
contracts greater than they are for interest rate contracts?

9
The credit conversion factors for the potential exposure of foreign exchange contracts are
greater than they are for interest rate contracts because research indicates that foreign
exchange rates are more volatile than interest rates.

e. Why do regulators not allow banks to benefit from positive current exposure values?

Regulators fear that allowing banks to gain from a counterparty default would create risk-
taking incentives that would not be in the best interests of the bank or the financial services
industry.

24. What is the process of netting off-balance-sheet derivative contracts? What requirement is
necessary to allow a bank to calculate this exposure? How is the net current exposure
defined? How does the net potential exposure differ from the net current exposure?

A large commercial bank may have exposure from many derivative contracts at any given time,
and thus it may be desirable to net or combine the various positive and negative exposures to
determine one total net exposure. The Fed allows this netting or combining of exposures under
the condition that the bank has a bilateral netting contract that clearly establishes a legal
obligation by the counterparty to pay or receive a single net amount on the contracts. The bank
must estimate the net current exposure and the net potential exposure of the positions included in
the bilateral netting contract.

The net current exposure is the net sum of all positive and negative replacement costs. If the
value is positive, the net current exposure is equal to the amount. If the net sum is negative, the
net exposure is zero.

The net potential exposure is determined by calculating a weighted average of the sum of the
potential exposures of each contract and the product of the sum of the potential exposures
multiplied times the ratio of the net current exposure to gross current exposure (NGR). The
weights are 0.4 and 0.6 respectively. Thus the equation to determine the net potential exposure
is Anet = (0.4 x Agross ) + (0.6 x NGR x Agross).

25. How does the risk-based capital measure attempt to compensate for the limitations of the
static leverage ratio?

The RBC ratio (1) more systematically accounts for credit risk differences between assets, (2)
incorporates off-balance-sheet risk exposures, and (3) applies similare capital requirements
across all of the major banks.

26. Identify and discuss the problems with the risk-based capital approach to measuring capital
adequacy.

First the risk weights may not be true representations of the correct or necessary weights, or they
may not be in the correct proportion to each other. For example, does a weight of 100 percent
imply twice as much risk as a weight of 50 percent? Second, the fact that the exact weighting

10
process is know by bankers as well as regulators may give bankers an incentive to manipulate the
balance sheet assets to achieve desired RBC ratios. Third, the RBC ratio does not consider the
effects of portfolio risk diversification. In effect, RBC assumes the correlation between assets is
one. Fourth, rating all commercial loans with the highest credit risk may cause banks to reduce
lending in this area, an action that could have negative effects on the monitoring function
performed by the financial services industry. Fifth, all commercial loans are given equal weight,
even in the case where the otherwise credit ratings of two companies may be significantly
different. Sixth, the BIS plan does not include factors to measure interest rate risk, foreign
exchange risk, operating risk, etc. Finally, tax and accounting differences across different
banking systems probably will preclude the BIS plan from being perfectly successful in creating
a level playing field for comparison purposes in an international or global environment.

27. What is the contribution to the asset base of the following items under the Basle
requirements? Under the U.S. capital-assets rule?
Basle U.S.
a. $10 million cash reserves. $0 $10 million
b. $50 million 91-day U.S. Treasury bills $0 $50 million
c. $25 million cash items in the process of collection. $5 million $0
d. $5 million U.K. government bonds $1 million $5 million
e. $5 million Australian short-term government bonds $1 million $5 million
f. $1 million general obligation municipal bonds $200,000 $1 million
g. $40 million repurchase agreements
(against U.S. Treasuries) $8 million $40 million
h. $500 million 1-4 family home mortgages $250 million $500 million
I. $500 million commercial and industrial loans $500 million $500 million
j. $100,000 performance related standby letters of credit
to a blue chip corporation $50,000 $0
k. $100,000 performance related standby letters of credit
to a municipality issuing general obligation bonds $10,000 $0
l. $7 million commercial letter of credit
to a foreign corporation $1.4 million $0
m. $3 million 5-year loan commitment
to an OECD government $300,000 $0
n. $8 million bankers acceptance conveyed
to a U.S. corporation $1.6 million $0
o. $17 million 3-year loan commitment to a private agent $8.5 million $0
p. $17 million 3-month loan commitment to a private agent $0 $0
q. $30 million standby letter of credit to back a
corporate issue of commercial paper $30 million $0
r. $4 million 5-year interest rate swap with no current
exposure (the counter party is a private agent) $10,000 $0
s. $4 million 5-year interest rate swap with no current
exposure (the counter party is a municipality) $4,000 $0
t. $6 million 2-year currency swap with $500,000 current
exposure (the counter party is a private agent) $400,000 $0

11
The bank balance sheet information below is for questions 28-31.
Used for answers to 28-31
On Balance Sheet Items Category Face Value Weight Value
Cash 1 $121,600 0% $0
Short term government securities (<92 days) 1 5,400 0% $0
Long term government securities (>92 days) 1 414,400 0% $0
Federal Reserve Stock 1 9,800 0% $0
Repos secured by Federal Agencies 2 159,000 20% $31,800
Claims on U.S. Depository Institutions 2 937,900 20% $187,580
Short term (<1yr) claims on foreign banks 2 1,640,000 20% $328,000
General Obligations Municipals 2 170,000 20% $34,000
Claims on or guaranteed by Federal agencies 2 26,500 20% $5,300
Municipal Revenue Bonds 3 112,900 50% $56,450
Loans 4 6,645,700 100% $6.6457 million
Claims on Foreign banks (>1yr.) 4 5,800 100% $5,800

Conversion Face Adjusted


Off Balance Sheet Items: Factor Value Amount Value
U.S. Government Counterparty:
Loan Commitments:
< 1 year 0% $300 $0 $0
1-5 year 50% $1,140 $570 $0
Standby Letters of Credit
Performance Related 50% $200 $100 $0
Other 100% $100 $100 $0

U.S. depository institution counterparty:


Loan Commitments:
< 1 year 0% $1,000 $0 $0
> 1 year 50% $3,000 $1,500 $300
Standby Letters of Credit
Performance Related 50% $200 $100 $20
Other 100% $56,400 $56,400 $11,280
Commercial Letters of Credit 20% $400 $80 $16

State and local government counterparty:


Loan Commitments:
>1 year 50% $100 $50 $25
Standby Letters of Credit
Non-Performance Related 50% $135,400 $67,700 $33,850

Corporate customer counterparty:


Loan Commitments:
< 1 year 0% $2,980,000 $0 $0
>1 year 50% $3,046,278 $1,523,139 $1,523,139

12
Standby Letters of Credit
Performance Related 50% $101,543 $50,772 $50,772
Other 100% $485,000 $485,000 $485,000
Commercial Letters of Credit 20% $78,978 $15,796 $15,796
Note Issuance Facilities 50% $20,154 $10,077 $10,077
Forward Agreements 100% $5,900 $5,900 $5,900
Category II Interest Rate Market Contracts:
(Current exposure assumed to be zero.)
< 1 year (Notional Amount) 0% $2,000 $0 $0
> 1-5 year (Notional Amount) 0.5% $5,000 $25 $12.5

28. What is the bank's risk-adjusted asset base?

On-balance-sheet risk-adjusted asset base $7,294,630


Off-balance-sheet risk-adjusted asset base $2,136,188
Total risk-adjusted asset base $9,430,818

29. What are the bank's Tier I and total risk-based capital requirements?

Tier I: 4% Capital requirement x 9,430,818 = $377,233


Tier II: 8% Capital requirement x 9,430,818 = $754,465

30. Using the leverage ratio requirement, what is the minimum regulatory capital required to
keep the bank in the well-capitalized zone?

The bank has $10,249,000 in total assets. The minimum regulatory capital at 5% is $512,450.

31. What is the bank's capital level if the par value of its equity is $150,000; the surplus value
of equity is $200,000; and the qualifying perpetual preferred stock is $50,000? Does the
bank meet Basle (Tier I) capital standards? Does the bank comply with the well-
capitalized leverage ratio requirement?

Tier I capital = $400,000. Yes, the bank meets the standards because Tier I capital is above 4%,
i.e., $400,000/$9,430,818 = 4.24%. The bank does not comply with the well-capitalized
leverage ratio because the bank's primary assets ratio is only 400,000/10,249,000 = 3.90%.

32. How does the leverage ratio test impact the stringency of regulatory monitoring of bank
capital positions?

The stringency of regulatory monitoring is increased because even if the bank can reduce its
capital requirement by adjusting its portfolio toward less capital-intensive assets, the primary
assets ratio test sets a minimum required capital level against balance sheet assets.

13
33. Third Bank has the following balance sheet (in millions) with the risk weights in
parentheses.

Assets Liabilities and Equity


Cash (0%) $20 Deposits $175
OECD Interbank deposits (20%) $25 Subordinated debt (2.5 years) $3
Mortgage loans (50%) $70 Cumulative preferred stock $5
Consumer loans (100%) $70 Equity $2
Total Assets $185 Total Liabilities & Equity $185

In addition, the bank has $30 million in performance-related standby letters of credit
(SLCs), $40 million in two-year forward FX contracts that are currently in the money by $1
million, and $300 million in six-year interest rate swaps that are currently out of the money
by $2 million. Credit conversion factors follow:
Performance-related standby LCs 50%
1-5 year foreign exchange contracts 5%
1-5 year interest rate swaps 0.5%
5-10 year interest rate swaps 1.5%

a. What are the risk-adjusted on-balance-sheet assets of the bank as defined under the
Basle Accord?

Risk-adjusted assets:
Cash 0 x 20 = $0
OECD interbank deposits 0.20 x 25 = $5
Mortgage loans 0.50 x 70 = $35
Consumer loans 1.00 x 70 = $70
Total risk-adjusted assets = $110 = $110

b. What is the total capital required for both off- and on-balance-sheet assets?

Standby LCs: $30 x 0.50 = $15 = $15

Foreign exchange contracts:


Potential exposure $40 x 0.05 = $2
Current exposure in the money = $0
Interest rate swaps:
Potential exposure $300 x 0.015 = $4.5
Current exposure Out-of-the money = $2
= $8.5 x 0.50 = $4.25
Total risk-adjusted on- and off-balance-sheet assets = $129.25
x 0.08
Total capital required = $10.34

14
c. Does the bank have enough capital to meet the Basle requirements? If not, what
minimum Tier 1 or total capital does it need to meet the requirement?

No, the bank does not have sufficient capital to meet the Basle requirements. In fact, it
needs Tier 1 = 129.25 x 0.04 = $5.17 and a similar amount for Tier 2. Since perpetual
preferred stock is limited to 25 percent of Tier 1, it needs a total of $4.136 million of Tier
1 capital.

New balance sheet:


Cash $22.136 Deposits $175
OECD interbank deposits $25 Subordinated debt (over 5 years) $3
Mortgage loans $ 70 Cumulative preferred stock $5
Consumer loans $70 Equity $4.136
Total $187.136 $187.136

34. Third Fifth Bank has the following balance sheet (in millions) with the risk weights in
parentheses.

Assets Liabilities and Equity


Cash (0%) $20 Deposits $130
Mortgage loans (50%) $50 Subordinated debt (> 5 years) $5
Consumer loans (100%) $70 Equity $5
Total Assets $140 Total Liabilities & Equity $140

In addition, the bank has $20 million (100 percent) in commercial standby letters of credit
and $40 million in 10-year forward contracts that are in the money by $1 million.

a. What are the risk-adjusted on-balance-sheet assets of the bank as defined under the
Basle Accord?

Risk-adjusted on-balance-sheet assets: $20 x 0 = $0


$50 x 0.50 = $25
$70 x 1.00 = $70
Total = $95

b. What is the total capital required for both off- and on-balance-sheet assets?

Total capital required:


On-balance-sheet: $95 x 0.08 = $7.6
Off-balance-sheet $20 x 0.08 = $1.6
Derivatives:
Potential exposure $40 x 0.075 = $3.0
Current exposure = $0.0
Total capital for = $3.0 x 0.50 =1.5 x 0.08 = $0.12
= $9.32

15
c. Does the bank have sufficient capital to meet the Basle requirements? How much
excess? How much short?

Yes. The bank has a surplus of $0.68 million ($5 +$5 - $9.32).

35. According to SEC Rule 15C 3-1, what adjustments must securities firms make in the
calculation of the book value of net worth?

Broker-dealers must calculate a market value for their new worth on a day-to-day basis and
ensure that their net worth to assets ratio exceeds two percent. This process is a three-step
process. First, fixed assets not readily convertible to cash are subtracted from net worth.
Second, securities that cannot be publicly sold and certain other haircut deductions are
subtracted. Third, other adjustments may be required. These adjustments may involve
unrealized profits and losses, subordinated liabilities, contractual commitments, deferred taxes,
options, commodities and commodity futures, and certain collateralized liabilities.

36. A securities firm has the following balance sheet (in millions):

Assets Liabilities and Equity


Cash $40 5-day commercial paper $20
Debt securities $300 Bonds $550
Equity securities $500 Debentures $300
Other assets $60 Equity $30
Total Assets $900 Total Liabilities & Equity $900

The debt securities have a coupon rate of 6 percent, have 20 years remaining until maturity,
and trade at a yield of 8 percent. The equity securities have a market value equal to book
value, and the other assets represent building and equipment which was recently appraised
at $80 million. The company has 1 million shares of stock outstanding, and its price is $35
per share. Is this company in compliance with SEC Rule 15C 3-1?

The market value of the bonds held by the firm is


($60xPVIFAn=20,i=.08 + $1,000xPVIFn=20,i=.08 )x300,000 = $241,091,115.55. Thus the market
value of the assets is ($40 + $241 + $500 + $80) = $861. The market value of the equity is $35,
so the net worth to asset ratio is $35/$861 = .0407. Therefore the company is in compliance with
SEC Rule 15C 3-1. Note, for the balance sheet to balance, the market value of the bonds and
debentures on the liability side must equal $806.

16
37. An investment bank specializing in fixed-income assets has the following balance sheet (in
millions). Amounts are in market values, and all interest rates are annual unless mentioned
otherwise.

Assets Liabilities and Equity


Cash $0.50 5% 1-year Eurodollar deposits $5.0
6% 2-year subordinated debt
8% 10-year Treasury-notes (par=10) $10.0
semi-annual (par value $16) $15.0 Equity $0.5
Total Assets $15.5 Total Liabilities & Equity $15.5

Assume that the haircut for all assets is 15 basis points and for all liabilities is 25 basis points
(per annum).

a. Does the investment bank have sufficient liquid capital to cushion any unexpected
losses as per the net capital rule?

Change in the value of the assets:


For 15% basis point change $15 = PVIFAn=20,k=?($0.64) + PIFVn=20,k=?($16)
k = 4.4796 x 2 = 8.9593 percent. If k =8.9593 + 0.15 = 9.1093/2 = 4.5246 percent,
the PV of the notes will be: PVIFAn=20,k=4.5246($0.64) + PIFVn=20,k=4.5246($16) = $14.8511
And the decrease in value is $14.8511 - $15.0 = - $148,885.99

Change in the value of deposits:


$5 = PVIFAn=1,k=?($0.25) + PIFVn=1,k=?($5) k=5 percent. If k =5.0 + 0.25 = 5.25 percent,
the value of the notes will be: PVIFA n=1,k=5.25 ($0.25) + PIFVn=1,k=5.25 ($5) = $4.9881. And
the market value will decrease by $4.9881 - $5 = -0.0119 x 1,000,000 = $11,876.49.

Change in the value of debt:


$10 = PVIFAn=2,k=?($0.60) + PVIFn=2,k=?($10) k=6 percent. If k =6 + 0.25 = 6.25 percent,
the value of the notes will be: PVIFAn=2,k=6.25($0.60) + PVIFn=2,k=6.25 ($10) = $9.9543. And
the decrease in value will be $9.9543 - $5 = -0.0457 x 1,000,000= $45,674.74.

The decline in the value of equity = $148,885.99 - $11,876.49 - $45,674.74 = $91,334.77.


Yes, it does have enough cash to meet a decline of 15 basis points in interest rates. Note
that the decrease in value of $91,334.77 is equivalent to $0.091 million.

b. What should the FI do to maintain the net minimum required liquidity?

If it becomes insufficient, it has to increase its equity or convert some assets into cash or
change the duration of its assets.

c. How does the net capital rule for investment banks differ from the capital requirements
imposed on commercial banks and other depository institutions?
The difference between banking institution and securities firms are:

17
(a) No netting is done for banking institutions. In securities firms, both assets and liabilities
are netted.
(b) In securities firms, cash is the cushion. With banks it is the capital (Tier I and II).
(c) Haircuts are based on years to maturity, liquidity, ratings, and other factors.

38. Identify and define the four risk categories incorporated into the life insurance risk-based
capital model.

a. Asset risk reflects the riskiness of the asset portfolio, and it is calculated on an asset-risk-
weighted basis similar to the risk-adjusted asset calculation for banks.

b. Insurance risk measures the risk of mortality (risk of death) and morbidity (risk of ill
health).

c. Interest rate risk measures the liquidity of liabilities and their probability or ease of
withdrawal as interest rates change. This measure is calculated on a risk-adjusted basis
after classifying liabilities into three risk classes.

d. Business risk deals with the cost of insurer insolvencies.

39. A life insurance company has estimated the following capital requirements for each of the
risk classes: asset risk (C1) = $5 million, insurance risk (C2) = $4 million, interest rate risk
(C3) = $1 million, and business risk (C4) = $3 million.

a. What is the required risk-based capital for the life insurance company?

2 2
RBC = (C1 + C3 ) + C 2 2 + C4 = RBC = (5 + 1 ) + 42 + 3 = $10.211 million

b. If the total surplus and capital held by the company is $9 million, does it meet the
minimum requirements?

No; total capital and surplus is not sufficient since (Total capital + Surplus)/ RBC < 1:
$9/10.211 = 0.8814

c. How much capital must be raised to meet the minimum requirements?

It needs to raise its total capital and surplus to $10.211 million, or a total additional amount
of $1.211 million.

40. How do the risk categories in the risk-based capital model for property-casualty insurance
companies differ from those of life insurance companies? What are the assumed
relationships between the risk categories in the model?

The risk-based capital requirements model for property-casualty companies contains six risk
categories including three categories for asset risk. Two of the asset risk factors, the credit risk
factor, and the two underwriting risk factors are assumed to be independent of each other.

18
Further the investment risk in PC affiliates is assumed to be perfectly correlated with the net
amount of the other five risk categories.

41. A property-casualty insurance company has estimated the following required charges for its
various risk classes (in millions):

Risk Description RBC Charge


R0 Affiliated P/C $2
R1 Fixed income $3
R2 Common Stock $4
R3 Reinsurance $3
R4 Loss adjustment expense $2
R5 Written premiums $3
Total $17

a. What is the RBC charge as per the model recommended by the NAIC?

RBC = R0 + R 12 + R 22 + R 32 + R 4 2 + R 52 = 2 + 32 + 42 + 32 + 22 + 32
= 2 + 6.8557 = $8.8557 million

b. If the firm currently has $7 million in capital, what should be its surplus to meet the
minimum capital requirement?

It needs to hold a minimum surplus of $1.8557 million.

19
Chapter Twenty One
Product Diversification
Chapter Outline

Introduction

Risks of Product Segmentation

Segmentation in the U.S. Financial Services Industry


Commercial and Investment Banking Activities
Banking and Insurance
Commercial Banking and Commerce
Nonbank Financial Service Firms and Commerce

Activity Restrictions in the United States versus Other Countries

Issues Involved in the Diversification of Product Offerings


Safety and Soundness Concerns
Economies of Scale and Scope
Conflicts of Interest
Deposit Insurance
Regulatory Oversight
Competition

Summary

255
Solutions for End-of-Chapter Questions and Problems: Chapter Twenty One

1. How does product segmentation reduce the risks of FIs? How does it increase the risks of
FIs?

Product segmentation reduces the risks of FIs by forcing them to specialize. Specialization
generates expertise and access to information, which should enable FIs to more accurately price
excessively risky situations. Product segmentation also increases the risk of the FI because the
benefits of diversification are reduced. Thus specialization leaves the FI more exposed to
downturns in the specific market to which it is confined.

2. In what ways have other FIs taken advantage of the restrictions on product diversification
imposed on commercial banks?

Money market mutual funds that offer checking account-like deposits services have removed low
cost deposits from bank balance sheets. Insurance companies have successfully offered annuities
as savings products to compete with bank CDs. The commercial paper market has provided very
effective competition for commercial lending activities of banks, and unregulated finance
companies continue to make market share gains in the business credit market.

3. How does product segmentation reduce the profitability of FIs? How does product
segmentation increase the profitability of FIs?

Product segmentation reduces the profitability of FIs by preventing them from exploiting
economies of scope across products. Moreover, tie-in sales across markets are restricted.
Customers are lost to FIs that could more completely supply all of their customers' financial
services needs. Since customer relationships produce information and are profitable, this reduces
the profitability of segmented FIs. Product segmentation also increases the profitability of FIs by
providing incentives for the FI to develop technology and other innovations to improve
production efficiency.

4. What general prohibition regarding the activities of commercial banking and investment
banking did the Glass-Steagall Act impose? What investment banking activities have been
permitted for U.S. commercial banks?

Sections 16 and 21 of the Glass-Steagall Act specifically prohibited banks from engaging in the
underwriting, issuing, and distributing of stocks, bonds, and other securities, while specifically
prohibiting investment banks from taking deposits and making commercial loans.

See Table 21-2 for specific Glass-Steagall language. Commercial banks have been the following
securities activities: a) underwriting U.S Treasury and U.S. agency securities, b) underwriting
general obligation municipal securities, c) the private placement of bonds and equity securities,
d) underwriting and dealing in securities offshore, e) mergers and acquisitions, f) individual trust
accounts, g) dividend investment service, h) brokerage services, i) securities swaps, and j)
research advice to investors separate from brokerage.

256
5. What restrictions were placed on section 20 subsidiaries of U.S. commercial banks that
make investment banking activities other than those permitted by the Glass-Steagall Act
less attractive? How does this differ from banking activities in other countries?

Although banks are allowed to engage in otherwise ineligible investment banking activities by
creating Section 20 subsidiaries, the revenue from these ineligible activities cannot exceed more
than 50 percent of the total revenue of the security firm affiliations. Consequently, only the large
banks with businesses in activities permitted under the Glass-Steagall Act, such as trading U.S.
Treasuries or general obligation municipal bonds are able to undertake the ineligible activities. In
addition, a stringent firewall between Section 20 subsidiaries and the commercial banks makes it
difficult for banks to exploit economies of scale and diversification benefits. In most countries
(except for Japan) both commercial and investment banking activities are undertaken under one
roof, allowing full flexibility and benefits of integrated operations.

6. A section 20 subsidiary of a major U.S. bank is planning to underwrite corporate securities


and expects to generate $5 million in revenues. It currently underwrites U.S. Treasury
securities and general obligation municipal bonds, earning annual fees of $40 million.

a. Is the bank in compliance with the current laws regulating the revenue generation of
section 20 subsidiaries? With the laws in place prior to 1999?

Yes, the bank is in compliance with the laws, because its revenues are less than 50 percent
of the total revenues earned from allowable investment banking activities.

b. The bank plans to increase its private placement activities, and expects to generate $11
million in revenue. Is it in compliance with the revenue generation requirements?

Yes, the bank is in compliance because private placement activity is one of the permissible
activities in the Glass-Steagall Act.

c. If it plans to increase underwriting of corporate securities and generate $11 million in


revenues, is it in compliance? If not, what should it do to ensure that it is in
compliance?

Yes, the bank is in compliance because its revenues from ineligible activities do not exceed
the 50 percent of total revenues earned from allowable investment banking activities in the
Glass-Steagall Act [$11/($40 + $11) = 21.57 percent]. It can undertake these activities as
long as it generates no more than $40.00 million in the ineligible activities. [X/($40 + X) =
0.50 X = $40.00]

7. Explain in general terms what impact the Financial Services Modernization Act of 1999
should have on the strategic implementation of section 20 activities.

The Financial Services Modernization Act of 1999 allows the creation of financial services
holding companies that can engage in banking activities and securities activities. The securities
activities are allowed through the creation of Section 4(k)(4)(e) subsidiaries that replace the

257
Section 20 subsidiaries. Thus banks are able to underwrite securities providing that the activity
is placed in a subsidiary under the regulation of the Office of the Comptroller of the Currency.
Thus full service financial institutions are available to compete with those of many other
countries in the world.

8. The Garn-St Germain Act of 1982 and several subsequent banking laws clearly established
the separation of banking and insurance firms. What were the likely reasons for
maintaining this separation?

Typically, an insurance company (say, life insurance) has long-term policy liabilities, whereas a
bank has short-term deposit liabilities. The insurance company must price the policy according
to actuarial determinants of risk of payout. The bank prices risky loans on the basis of an
assessment of risk exposure given past experience and borrower attributes. Since bank deposit
liabilities receive federal protection via deposit insurance, there was concern that expansion of
banking powers to include insurance would extend the deposit insurance safety net to the
insurance industry. This would remove some of the risk of capital loss from insurance policy
pricing. If the deposit insurance guarantee was implicitly transferred to insurance lines (through,
say, protection of big banks from failure), then this could lead to below actuarially fair insurance
policy pricing. Bank provided insurance would have a competitive pricing advantage and the
deposit insurance guarantee (and therefore potential federal liability) would be greatly expanded.

Often, insurance company guarantees complement bank loans. That is, personal (mortgage or
other) loans often are backed up by an insurance policy on the life of the borrower. Moreover,
for commercial and industrial borrowers, a P-C insurer will often provide protection for the bank
against destruction of any assets that might be used as collateral against a loan. Thus, the
combination of banking and insurance would increase bank risk exposure by eliminating this
independent source of protection.

However, more likely than not, the explanation for the exclusion of insurance from the expanded
range of banking powers was political. The insurance lobby was successful in maintaining the
protected status of the industry.

9. What types of insurance products were commercial banks permitted to offer before 1999?
How did the Financial Services Modernization Act of 1999 change this?

Commercial banks were prohibited from offering almost all insurance products with the
exception of annuities, life, health, and accident insurance related to credit products, and some
forms of employment related insurance. The Financial Services Modernization Act of 1999
allowed bank holding companies to open affiliates to underwrite insurance and to sell insurance
under the same regulations as the insurance industry.

10. How have nonbanks managed to exploit the loophole in the Bank Holding Company Act of
1956 and engage in banking activities? What law closed this loophole? How did insurance
companies circumvent this law?

258
The Bank Holding Company Act of 1956 legally defined a bank as an organization that accepted
demand deposits and made commercial and industrial loans. By acquiring banks and
subsequently divesting off either their deposits or their loans, nonbanks and commercial firms
gained control over banking institutions, essentially exploiting a loophole. The 1987 Competitive
Equality Banking Act redefined a bank as any institution that accepts deposit insurance, thereby
closing this loophole, although nonbanks prior to the passage of the law were allowed to operate
as before.

11. The Financial Services Modernization Act of 1999 allows banks to own controlling
interests in nonfinancial companies. What are the two restrictions on such ownership?

First, the investment cannot be made for an indefinite period of time, although the act did not
specify a definition for the word indefinite. Second, the bank cannot become actively involved
in the management of the corporation in which it invests.

12. What are the restrictions on the structure of a financial services holding company as
specified by the Financial Services Modernization Act of 1999?

A financial services holding company must hold a minimum of 85 percent of its assets in
financial assets. Through mergers and acquisitions this constraint may be violated for 10 to 15
years, but eventually real sector assets and activities must be liquidated to compliance.

13. What are the differences in the risk implications of a firm commitment securities offering
versus a best-efforts offering?

Under a best-efforts basis, the underwriting firm serves as a placement agent with the promise to
do the best job possible. The firm has very little risk of loss in this situation. In a firm
commitment offering, the investment bank actually buys the securities from the issuing firm and
then must resell them to the public in the market. The investment firm faces two risks in this
process. First, the securities cannot be sold at any price different from the negotiated price in
effect during the offering window or period. Second, if adverse events occur during this
window, the investment firm may be unable to sell the securities and will either hold the
securities in inventory or sell them at a reduced price after the offering period. In either case, the
investment firm is at risk to suffer a loss.

14. An FI is underwriting the sale of 1 million shares of Ultrasonics, Inc and is quoting a bid-
ask price of $6.00-6.50.

a. What are the fees earned by the FI if a firm commitment method is used to underwrite
the securities?

Firm commitment: ($6.50 - $6.00) x 1 million = $500,000

b. What are the fees if it uses the best-efforts method and a commission of 50 basis points
is charged?

259
Best efforts: 0.005 x $6.50 x 1 million = $ 32,500

c. How would your answer be affected if it only manages to sell the shares at $5.50 using
the firm commitment method? The commission for best efforts is still 50 basis points.

Best efforts: 0.005 x $5.50 x 1 million = $27,500


Firm commitment: ($5.50 - $6.00) x 1 million = -$500,000

15. What is the maximum possible underwriters fee on both the best-efforts and firm
commitment underwriting contracts on an issue of 12 million shares at a bid price of
$12.45 and an offer price of $12.60? What is the maximum possible loss? The best efforts
underwriting commission is 75 basis points.

Maximum gain:
Best efforts: $12.60 x 12 million x 0.0075 = $1.134 million
Firm commitment: ($12.60 - $12.45) x 12 million = $1.8 million
Maximum loss: (the IPO share price = $0)
Best efforts: $0 x 12 million x 0.0075 = $0 loss
Firm commitment: ($0 - $12.45) x 12 million = -$149.4 million

16. A section 20 affiliate agrees to underwrite a debt issue for one of its clients. It has
suggested a firm commitment offering for issuing 100,000 shares of stock. The bank quotes
a bid-ask spread of $97-$97.50 to its customers on the issue date.

a. What are the total underwriting fees generated if all the issues are sold? If only 60
percent is sold?

If all shares are sold, underwriting fees = 100,000 x $0.50 = $50,000. If only 60 percent
are sold, the fee will depend on what price the remaining 40 percent are sold. Most likely
the affiliate will keep it in inventory and try to sell them at a later date when the price for
these shares has stabilized.

b. Instead of taking a chance that only 60 percent of the shares will be sold on the issue
date, a bank suggests a price of $95 to the issuing firm. It expects to quote a bid-ask
rate of $95-$95.40 and sell 100 percent of the issue. From the FIs perspective, which
price is better if it expects to sell the remaining 40 percent at the bid price of $97 under
the first quote?

If the price quoted is $95.00-$95.40, its underwriting fees = 100,000 x $0.40 = $40,000. If
60 percent is sold at $97.50, the underwriting fees = 60,000 x 0.50 = $30,000. If the
remaining 40 percent are sold at $97, the underwriting fee is $0 for that portion, and the
total fees generated = $30,000. Clearly the FI should recommend an issue price of $95
instead of $97.

17. What are the reasons why the upside returns from firm commitment securities offerings are
not symmetrical to the downside risk?

260
The upside returns from firm commitment underwriting efforts are capped because the price at
which the securities are sold to the public cannot be increased even when the market seems to
value the shares at a higher price. On the other hand, the underwriter may not be able to sell the
shares at the offer price if the shares were overpriced. In this case the shares unsold during the
initial offering period will need to be sold at a lower price, and the underwriter stands to lose a
larger amount.

18. What are three ways that the failure of a securities affiliate in a holding company
organizational form could negatively affect a bank? How has the Fed attempted to prevent
a breakdown of the firewalls between banks and affiliates in these situations?

An FI could be affected negatively in three ways if its securities affiliate fails. First, the holding
company could upstream resources by increasing dividend and other fee payments from the bank
to the holding company. To prevent excessive upstream, the Fed has restricted dividend
payments if an FI is undercapitalized. In addition, Section 23B of the 1982 Federal Reserve Act
prevents affiliates from charging fees above the normal rate charged by other institutions.

Second, a holding company could compel the bank to make interaffiliate loans to its loss-making
unit. Section 23A of the Federal Reserve Act prevents banks from making loans to their affiliates
in excess of 10 percent of their capital. In the case of Section 20 affiliates, no loans are permitted
by their bank affiliates.

Third, a securities affiliate that incurs losses may induce depositors to engage in a run on the
bank even though the Fed requires strict separation between the bank and nonbank affiliates.
This is even more likely if the two affiliates bear a common name, such as Chase bank and
Chase Securities. Such contagion effects cannot be controlled by the Fed except through
publicizing the information on the soundness of the firewall between the institutions.

19. What are two operational strategies to reduce the risk to safety and soundness of the bank
resulting from the failure of a securities affiliate or many other types of financial distress?

First, a well-diversified financial services firm enjoys a more stable earnings and profit stream
than does a product-specialized bank. Second, risk-reduction gains can be achieved when there
are regional imperfections in the costs of raising debt and equity.

20. What do empirical studies reveal about the effect of activity diversification on the risk of
failure of banks?

The lower the correlation among the different activities, the greater is the potential gains and less
risk from these activities.

21. What role does bank activity diversification play in the ability of a bank to exploit
economies of scale and scope? What remains as the limitation to creating potentially
greater benefits?

261
Most research studies have found revenue based economies of scope at large FIs, although
economies of scale opportunities may be available to FIs with total assets under $25 billion. The
firewalls between banks and investment affiliates may be limiting the realization of greater
benefits from revenue and cost synergies.

22. What six conflicts of interest have been identified as potential roadblocks to the expansion
of banking powers into the financial services area?

The six conflicts of interest are (1) the incentive interest of the salesperson to sell rather than to
just provide dispassionate advice, (2) the opportunity to sell unwanted securities in a firm
commitment underwriting to trust department accounts within the bank, (3) the ability to
encourage a creditor to issue bonds and to use the proceeds to pay down the bank loan under
conditions where the creditors bankruptcy risk has increased, (4) the incentive to lend to third-
party investors for the purpose of buying securities that ore offered by the investment affiliate,
(5) the opportunity to tie lending availability to the use of the investment affiliate products for
securities needs, and (6) the opportunity to misuse inside information.

23. What are some of the legal, institutional, and market conditions that lessen the likelihood
that an FI can exploit conflicts of interest from the expansion of commercial banks into
other financial service areas?

Many of the activities such as tie-ins and third party loans described as a conflict of interest are
against the law. Second, banks have set up Chinese walls that inhibit the transfer of information
that could benefit the bank at the expense of a customer. Finally, the existence of a conflict
presumes that the market for bank services is not competitive with asymmetric information
between customers and banks, and that banks are unconcerned or unaffected by damage to its
reputation.

24. Under what circumstances could the existence of deposit insurance provide an advantage to
banks in competing with other traditional securities firms?

The provision of insurance for deposits up to $100,000 provides banks with a source of funds at
below-market cost. If these funds are loaned to securities affiliates at less than market rates, the
affiliates have received explicit benefits. In cases where the regulators implement the too big to
fail (TBTF) guarantee, the institution may take excessive risk by placing aggressive bids for new
issues. In these cases the TBTF guarantees provide unfair competitive advantages.

25. In what ways does the current regulatory structure argue against providing additional
securities powers to the banking industry? Does this issue concern only banks?

The regulatory structure for most banks is multilayered and complex. The efficiency of the
overlapping structure is questionable from a public policy perspective because of the waste of
monitoring and surveillance resources as well as the inherent coordination problems. Further,
these problems may become magnified in times of financial distress regardless of the source,
causing potentially serious negative effects to occur for shareholders, customers, and the general
financial system

262
26. What are the potential procompetitive effects for allowing banks to enter more fully into
securities underwriting? What is the anticompetitive argument or position?

The procompetitive arguments include (1) the increased access to capital markets for small firms,
(2) the reduced commissions and fees to the securities issuers caused by the increased
competition, and (3) the decrease in securities underpricing. Each of the last two arguments
would result because of increased competition for the underwriting business. The
anticompetitive argument is the potential for an increase in market concentration in the long-run
as large banks force traditional investment houses out of business with aggressive pricing. In
this case the cost to issue securities ultimately could rise.

263
Chapter Twenty Two
Geographic Diversification: Domestic
Chapter Outline

Introduction

Domestic Expansions

Regulatory Factors Impacting Geographic Expansion


Insurance Companies
Thrifts
Commercial Banks

Cost and Revenue Synergies Impacting Geographic Expansion by Merger or Acquisition


Cost Synergies
Revenue Synergies

Other Market- and Firm-Specific Factors Impacting Geographic Expansion Decisions

The Success of Geographic Expansions


Investor Reaction
Postmerger Performance

Summary

264
Solutions for End-of-Chapter Questions and Problems: Chapter Twenty Two

1. How do limitations on geographic diversification affect an FIs profitability?

Limitations on geographic diversification increase FI profitability by creating locally


uncompetitive markets. FIs in these markets earn monopoly rents that are protected by
limitations on geographic expansion by potential competitors. Limitations on geographic
diversification reduce FI profitability by preventing the FI from exploiting any economies of
scale and/or scope or revenue synergies that may be available.

2. How are insurance companies able to offer services in states beyond their state of
incorporation?

Insurance companies are state-regulated firms that are not prohibited from establishing
subsidiaries and offices in other states. Further, the capital requirements are kept low by state
regulators.

3. In what way did the Garn-St Germain Act and FIRREA provide incentives for the
expansion of interstate branching?

Both legislative acts provided for sound banks and thrifts to acquire failing banks and thrifts
across state lines. These acquisitions could be operated either as separate subsidiaries or as
branches of the acquiring institution.

4. Why were unit and money center banks opposed to bank branching in the early 1900s?

Smaller unit banks were afraid of losing retail business to the larger branching banks, and the
larger money center banks were afraid of losing correspondent business such as check clearing
and other payment services.

5. In what ways did the banking industry continuously succeed in maintaining interstate
banking activities during the 50-year period beginning in the early 1930s? What legislative
efforts did regulators use to respond to each foray by banks into previously prohibited
banking and commercial activities?

The McFadden Act of 1927 restricted the branching activity of nationally chartered banks to the
same extent allowed for state-chartered banks that generally were disallowed from such activity.
As a result, the banking industry attempted to circumvent the prohibition of interstate banking by
establishing subsidiaries rather than branches under the holding company organizational form.
The Douglas Amendment to the Bank Holding Company Act restricted the acquisition of
banking units to the state-allowed activities. However, the law did not prohibit one-bank holding
companies from acquiring nonbank subsidiaries that sold financial products. Thus the path to
geographic expansion continued as banks searched for loopholes to circumvent the legislative
restrictions placed on their activities.

6. What is the difference between an MBHC and an OBHC?

265
A multibank holding company is a parent organization that owns more than one bank subsidiary,
and a one-bank holding company is a parent organization that owns only one bank subsidiary.
Each organization may own other subsidiaries that provide services closely related to banking as
allowed by regulatory authorities.

7. What is an interstate banking pact? How did the three general types of interstate banking
pacts differ in their encouragement of interstate banking?

An interstate banking pact is an agreement between states defining the conditions under which
out-of-state banks can acquire in-state subsidiaries. A major feature of these pacts normally was
the reciprocity conditions awarded each state involved. A nationwide pact allowed out-of-state
banks to purchase target banks even if the acquirers state did not allow such activity. A
nationwide reciprocal pact allowed purchase only if the acquirers state allowed the same
activity. Third, a regional pact allowed out-of-state acquisitions within a small number of states
only under conditions of reciprocity.

8. What significant economic events during the 1980s provided the incentive for the Garn-St
Germain Act and FIRREA to allow further expansion of interstate banking?

The bankruptcy of the FSLIC and the depletion of the FDICs insurance reserves provided
incentives to allow out-of-state acquisitions to resolve bank failures. The Garn-St Germain Act
allowed banks to acquire failing thrifts across state lines. Finally, FIRREA allows for the
purchase across state lines of healthy thrifts.

9. What is a nonbank bank? What legislation allowed the creation of nonbank banks? What
role did nonbank banks play in the further development of interstate banking activities?

A nonbank bank is a financial institution that did not meet the requirement of (1) making
commercial loans and (2) accepting demand deposits as defined in the 1956 Bank Holding
Company Act. By purchasing an out-of-state bank and divesting its commercial loans, a large
bank or bank holding company could create a nonbank bank that could be used to provide retail
or consumer finance banking activities. This loophole was not closed until the Competitive
Equality Banking Act of 1987.

10. How did the development of the nonbank bank competitive strategy further clarify the
meaning of the term activities closely related to banking? In a more general sense, how has
this strategy assisted the banking industry in their attempts to provide services and products
outside the strictly banking environment?

The Bank Holding Company Amendments of 1970 specified that nonbank activities had to be
closely related to banking. As the growth rate of nonbank acquisitions increased, so too did the
pressure on the Federal Reserve to expand the list of these acceptable activities. The nonbank
subsidiaries eventually were allowed to provide more than 60 different types of financial
products. Thus banks learned how to replicate full-scale (or nearly) banking institutions without
having a legally defined bank.

266
11. How did the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994 allow for full interstate banking? What are the expected profit performance
effects of interstate banking? What has been the impact on the structure of the banking and
financial services industry?

The main feature of the Riegle-Neal Act of 1995 is the removal of barriers to interstate banking.
In September 1995, bank holding companies were allowed to acquire banks in other states. In
1997, banks were allowed to convert out-of-state subsidiaries into branches of a single interstate
bank. The act has resulted in significant consolidations and acquisitions, with the emergence of
very large banks with branches all over the country, as currently practiced in the rest of the
world. The law, as of now, does not allow the establishment of de novo branches unless allowed
by the individual states. As expected, profit performance of the largest banks has been very good
over the period 1995 to 1999.

12. Bank mergers often produce hard to quantify benefits called X efficiencies and costs called
X inefficiencies. Give an example of each.

An X efficiency is a cost saving that is difficult to measure and whose source is difficult to
identify. One common example is the reduction in expenses thought to be derived from greater
managerial efficiency of an acquiring bank. X inefficiencies occur when a merger results in cost
increases that are usually attributed to managements inability to control costs.

13. What does the Berger and Humphrey study reveal about the cost savings from bank
mergers? What differing results are revealed by the Rhoades study?

Berger and Humphrey found that (1) the managerial efficiency of the acquirer is greater than that
of the acquiree, (2) the X efficiency gains were small, and (3) the cost savings of mergers with
geographic overlap were no greater than those for mergers with no geographic or market share
overlap. Rhoades reviewed nine megamergers and found large cost savings. In those cases
where cost efficiency gains were not realized, the problems were from integrating data
processing and operating systems.

14. What are the three revenue synergies that may be obtained by an FI from expanding
geographically?

The three revenue synergies that an FI may obtain by expanding geographically are as follows:
(a) Opportunities to increase revenue because of growing market share.
(b) Different credit risk, interest rate risk and other risks that allow for diversification benefits
and the stabilization of revenues.
(c) Expansion into less-than-competitive markets, which provides opportunities to reap some
economic rents that may not be available in competitive markets.

15. What is the Herfindahl-Hirschman Index? How is it calculated and interpreted?

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration whose value can
be 0 to 10,000. The index is measured by adding the squares of the percentage market share of

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the individual firms in the market. An index value greater than 1,800 indicates a concentrated
market, a value between 1,000 and 1,800 indicates a moderately concentrated market, and an
unconcentrated market would have a value less than 1,000.

16. City Bank currently has 60 percent market share in banking services, followed by
NationsBank with 20 percent and State Bank with 20 percent.

a. What is the concentration ratio as measured by the Herfindahl-Hirschman Index (HHI)?


2 2 2
HHI = (60) + (20) + (20) = 4,400

b. If City Bank acquires State Bank, what will be the new HHI?

HHI = (80)2 + (20)2 = 6,800

c. Assume the Justice department will allow mergers as long as the changes in HHI do not
exceed 1,400. What is the minimum amount of assets that City Bank will have to
divest after it merges with State Bank?

This is a little tricky. For City Bank to complete the merger, its maximum HHI should be
such that when it disposes of part of its assets, the HHI will be X2 + Y2 + Z 2 = 5,800. Since
2 2
Z = 20 percent, we need to solve the following: X + Y = 5,400; that is, 5,800 less the
2 2
share of Z which is 20 or 400.

If the merger stands with no adjustment, then X = 80 and Y = 0. But some portion of X
2 2
must be liquidated. Therefore we need to solve the equation (80 Q) + Q = 5,400 where
Q is the amount of disinvestment. This requires solving the quadratic equation of the form:
2 2 2
Q + (80 - Q) = 5,400 which expands and simplifies to 2Q 160Q + 1,000 = 0.
- b ( b2 - 4ac)
Using the formula: Q = , we get Q = 73.1662 percent, which means City
2a
Bank has to dispose of 6.8338 percent of total banking assets. To verify, we can check the
total relationship: (73.1662)2 + (6.8338)2 + (20)2 = 5,800.

17. The Justice Department has been asked to review a merger request for a market with the
following four FI's.
Bank Assets
A $12 million
B $25 million
C $102 million
D $3 million

a. What is the HHI for the existing market?

Bank Assets Market Share


A $12 m 8.45 %
B $25 m 17.61%

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C $102 m 71.83%
D $3 m 2.11%
100.00%
2 2 2 2
The HHI = (8.45) + (17.61) + (71.83) + (2.11) = 5,545.5

b. If Bank A acquires Bank D, what will be the impact on the market's level of
concentration?

Bank Assets Market Share


A $12 m 10.56%
B $25 m 17.61%
C $102 m 71.83%
100.00%

The HHI = (10.56)2 + (17.61)2 + (71.83) 2 = 5,581

c. If Bank C acquires Bank D, what will be the impact on the market's level of
concentration?

Bank Assets Market Share


A $12 m 8.45 %
B $25 m 17.61%
C $102 m 73.94%
100.00%

The HHI = (8.45)2 + (17.61) 2 + (73.94)2 + (2.11)2 = 5,848.6

d. What is likely to be the Justice Department's response to the two merger applications?

The Justice Department may challenge Bank Cs application to acquire Bank D since it
significantly increases market concentration (HHI = 5,848.6). On the other hand, the Justice
Department would most likely approve Bank A's application since the merger causes only a
small increase in market concentration (HHI = 5,581).

18. The Justice Department measures market concentration using the HHI of market share.
What problems does this measure have for (a) multiproduct FIs and (b) FIs with global
operations?

(a) The Herfindahl-Hirschman Index (HHI) for multiproduct firms is calculated either on the
basis of total assets or one particular product (say, deposits). Neither solution is entirely
appropriate. Use of total assets distorts market share calculations since different FIs have
different product mixes. Moreover, an HHI based on total assets will not be accurate if
there are different market concentration levels in each product market.

269
(b) Since the calculation of the Herfindahl-Hirschman Index specifies a market area, results are
dependent upon the assumption of the appropriate geographic market. Global FIs will
undoubtedly have activities outside of the specified market area. If these are omitted in the
calculation of market shares, the FIs market share may be understated. However, if they
are included, this may overstate the global FIs market share and make the market appear to
be more concentrated than it is in actuality.

19. What factors, other than market concentration, does the Justice Department consider in
determining the acceptability of a merger?

Other factors considered by the Justice Department include ease of entry, the nature of the
product, the terms of sale of the product, market information about specific transactions, buyer
market characteristics, conduct of firms in the market, and market performance.

20. What are some plausible reasons for the percentage of assets of small banks decreasing and
the percentage of assets of large banks increasing while the percentage of assets of
intermediate banks has stayed constant since 1984?

One reason for the decreasing share of small bank assets is the wave of mergers that has taken
place over the 13 year time period. If two small banks merge, the merged bank may have assets
that move it into the next higher asset category. The changes in the interstate banking laws have
encouraged this wave of mergers. Finally, the growth of the national economy has been
unprecedented during this time, which has caused the entire banking industry to perform well
since the late 1980s.

21. According to empirical studies, what factors have the highest impact on merger premiums
as defined by the ratio of a target banks purchase price to book value?

Premiums appear to be higher in states with the most restrictive regulations and for target banks
with high-quality loan portfolios. Interestingly, the growth rate of the target bank seems to have
little effect on bid premiums, and profitability and capital adequacy give mixed signals of
importance.

22. What are the results of studies that have examined the mergers of banks, including post-
merger performance? How do they differ from the studies examining mergers of nonbanks?

Most studies examining mergers between banks show that both bidding and target banks realize
an increase in market value. These results contrast with those of nonbanks studies where only
target firms benefit by an increase in stock prices (market value). Bidding firms experience either
no gains or in some cases, a decline in market value declines. In addition, studies have also
shown that post-merger banks increase their efficiency through reduced operating costs,
increased productivity, and enhanced asset growth.

23. What are some of the important firm-specific financial factors that influence the acquisition
of an FI?

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Some of the important factors are the leverage ratio, the amount of loss reserves, the loan to
deposit ratio, and the amount of nonperforming loans.

24. How has the performance of merged banks compared to that of bank industry averages?

Cornett and Tehranian found that merged banks tend to outperform the industry with significant
improvements in the ability to attract loans and deposits, increased employee productivity, and
enhanced asset growth. Spong and Shoenhair found that acquired banks maintain or increase
profits and become more active lenders. Boyd and Graham found that banks formed from the
merger of small banks also outperformed the industry.

25. What are some of the benefits for banks engaging in geographic expansion?

The benefits to geographic diversification are:

(a) Economies of scale: If there are efficiency gains to growth, geographic diversification can
reduce costs and increase profitability.

(b) Risk reduction: Overall risk reduction via diversification.

(c) Survival: As nonbank financial firms have increasingly eroded banks market share, banks
campaign to expand geographically can be viewed as a competitive response. That is, as
global FIs dominate the financial environment, larger institutions with presence in many
regions may better position the FI to compete.

(d) Managerial welfare maximization: Empirical evidence suggests that larger institutions offer
more lucrative compensation packages with greater amounts of perquisites for managers.
Growth via geographic diversification may therefore be in the interests of managers, but
not in the interests of stockholders unless the activities increase firm value.

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Chapter Twenty Three
Geographic Diversification: International
Chapter Outline

Introduction

Global and International Expansions


U.S. Banks Abroad
Foreign Banks in the United States
The International Banking Act of 1978

Advantages and Disadvantages of International Expansion


Advantages
Disadvantages

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter Twenty Three

1. What are three ways in which FI can establish a global or international presence?

The three most common methods are (1) selling financial services from domestic offices to
foreign customers, (2) selling financial services through a branch or representative office
established in the foreign customers country, and (3) selling financial services to a foreign
customer through subsidiary companies in a foreign customers country.

2. How did the Overseas Direct Investment Control Act of 1964 assist in the growth of global
banking activities? How much growth in foreign assets occurred from 1980 to 2003?
Which types of foreign assets saw the largest amount of growth?

The Overseas Direct Investment Control Act of 1964 restricted the ability of U.S. banks to lend
to U.S. corporations that wanted to make investments overseas. Although later repealed, the law
created incentives for U.S. banks to establish offices offshore to serve the financial needs of their
U.S. corporate clients. From 1980 to 2003, foreign assets of U.S. banks grew from $354 billion
to $804 billion, growth in foreign assets of 127% in 23 years. The largest dollar increase and the
largest percentage increase occurred in individual loans. These numbers are affected by the slow
economic activity of the first 3 years of this decade. Table 23-2 clearly shows that C&I loans
had shown the largest dollar increase through the end of 2000.

3. What is a Eurodollar transaction? What are Eurodollars?

Eurodollars are dollar-denominated claims at foreign or U.S. banks outside the United States.
The Eurodollar transaction may be a liability or an asset transaction that is booked external to the
boundaries of the United States.

4. Identify and explain the impact of at least four factors that have encouraged global U.S.
bank expansion.

First, the growth of international trade with the dollar as the primary medium of exchange has
encouraged the use of U.S. foreign bank subsidiaries to assist in these trade-related transactions.
Second, the U.S. banks in strategic locations, such as the Cayman Islands and the Bahamas,
became preferred depositories for funds that were flowing out of politically sensitive and risky
countries. Third, the Federal Reserve Bank often allowed U.S. banks to participate in activities
that were permitted in foreign countries, even though those same activities may not have been
permitted in the U.S. Finally, the technological improvements in communications, and the
development of an international payment system (CHIPS) provided banks with the control of
overseas operations at a decreasing rate.

5. What is the expected impact of the implementation of the revised BIS risk-based capital
requirements on the international activities of some major U.S. banks?

Several large banks may find it necessary to increase capital because only loans to OECD
countries rated above AA- will require zero risk weight or zero capital set aside.

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6. What effect have the problems of emerging-market economies in the late 1990s had on the
global expansion of traditional banking activities by U.S. banks?

Many U.S. banks have become more cautious in expanding outside the traditional overseas
markets even though the regulatory environment seems more favorable.

7. What factors gave the Japanese banks significant advantages in competing for international
business for an extended period of time through the mid-1990s? What are the advantages
of size in a competitive market? Does size necessarily imply high profitability?

Japanese banks had access to a large domestic savings base at relatively low cost, enjoyed a slow
pace of deregulation in their domestic markets, and were very large in asset size. The size
advantage gave these banks the ability to diversify across borders and attract business by
aggressively cutting fees and spreads. The size advantage of the Japanese banks deteriorated as
thin margins, an economic domestic recession, and increasing nonperforming assets weakened
the Japanese financial structure.

8. What is the European Community (EC) Second Banking Directive? What impact has the
Second Banking Directive had on the competitive banking environment of Europe?

The EC Second Banking Directive created a single banking market in Europe wherein banks
could branch and acquire banks throughout the entire European Community. As a result, a
significant cross-border merger wave among European banks has occurred, as well as the
development of strategic alliances that allow customers to utilize any of the branches of the
members of the alliances to open accounts, access account information, and make payments to
third parties. These actions obviously make a more competitive environment for U.S. banks.

9. Identify and discuss the various ways that foreign banks can enter the U.S. market. What
are international banking facilities?

First, a foreign bank subsidiary can be chartered with its own capital and access to both retail and
wholesale markets. Second, branch bank can be established with capital support from the parent,
but with access to both the retail and wholesale markets. Third, an agency organization is
restricted in its access of funds to those available in the wholesale and money markets. Fourth,
Edge Act Corporations specialize in international trade-related banking transactions. Fifth, a
representative office serves as a loan production office that generates loans that are booked in the
home country. International Banking Facilities are allowed to take deposits from and to make
loans to foreign customers only, effectively operating as offshore banking units onshore, but
without the effects of U.S. bank regulation and taxes.

10. What factors affected the relative growth of the proportion of U.S. banking assets that are
controlled by foreign banks during the 1990s into 2003?

Several factors have led to this decline including the highly competitive wholesale market for
banking in the United States, a decline in the quality of U.S. loans, capital constraints and poor
lending performance on Japanese banks at home, and the introduction of FBSEA in 1991.

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11. What was the fundamental philosophical focus of the International Banking Act (IBA) of
1978?

The IBA of 1978 and the Foreign Bank Supervision Enhancement Act of 1991 brought the
regulation of foreign banks under the control of federal regulators with the intent of treating them
under the same guidelines as domestic national banks.

a. What advantages and disadvantages did foreign banks have relative to domestic banks
prior to the passage of this legislation?

As state-licensed organizations, they were not subject to reserve requirements, audits, or


exams of the Federal Reserve System, interstate branching activities, or restrictions on
corporate securities underwiritng. At the same time, the international branches did not
have access to the Federal Reserve discount window, the fed funds market (Fedwire), or to
FDIC deposit insurance.

b. What requirements were placed on the foreign banks by the IBA?

The foreign branches were required to meet reserve requirements if their worldwide assets
exceeded $1 billion, made subject to Federal Reserve examinations, and made subject to
both McFadden Act interstate branching restrictions and the Glass-Steagall Act securities
underwriting restrictions.

c. What was the likely effect of the IBA on the growth of foreign bank activities in the
United States? Why?

Although restrictive in nature, the IBA also provided access to the discount window, the
Fedwire, and FDIC insurance. Thus foreign bank activities expanded in the United States.

12. What events led to the passage of the Foreign Bank Supervision Enhancement Act
(FBSEA) of 1991? What was the main objective of this legislation?

The primary objective of FBSEA was to extend federal regulatory authority over foreign banking
organizations in the United States. The three events that served as the catalyst for this legislation
were the failure of the Bank of Credit and Commerce International (BCCI), the issuance of more
than $1 billion of unauthorized letters of credit to Iraq by the Atlanta branch of Banca Nazionale
del Lavoro, and the unauthorized use of deposit funds by the U.S. representative office of the
Greek National Mortgage Bank of New York.

13. What were the main features of FBSEA? How did FBSEA encourage cooperation with the
home country regulator? What was the effect of the FBSEA on the Federal Reserve and on
the foreign banks?

The five main features of FBSEA are identified and discussed below:

275
Entry. The Fed must approve the establishment of a subsidiary, branch, agency, or
representative office in the United States. The two mandatory standards are (a) the
comprehensive supervision of the foreign bank on a consolidated basis by a home country
regulator, and (b) the provision by the home country regulator of all of the necessary
information needed by the Fed to evaluate the application.

Closure. The Fed has the power to close the foreign bank if (a) the home country supervision is
inadequate, (b) the bank has violated U.S. laws, and (c) the bank is engaged in unsound and
unsafe banking practices.

Examination. The Fed has the power to examine each office of a foreign bank, and must
examine at least annually each branch or agency.

Deposit taking. Only foreign subsidiaries with access to FDIC insurance are allowed to take
deposits under $100,000.

Activity powers. Effective December 19, 1992, state-licensed branches and agencies of foreign
banks could not engage in any activity not permitted to a federal branch.

Clearly the authority of the Federal Reserve over the foreign banks was increased. Further,
Further, the regulatory burden and the costs of entry by foreign banks into the United States also
increased.

14. What are the major advantages of international expansion to FIs? Explain how each
advantage can affect the operating performance of FIs?

First, an FI can benefit from significant risk diversification, especially if the economies of the
world are not perfectly integrated, or if different countries allow different banking activities.
Second, an FI may benefit from economies of scale. Third, the returns from new product
innovations may be larger if the market is international rather than just domestic. Fourth, the risk
and cost of sources of funds both should be reduced. Fifth, FIs should be able to maintain
contact with, and thus provide better service to, their international customers. Sixth, an FI may
be able to reduce its regulatory burden by selectively finding those countries that have lower
regulatory restrictions.

15. What are the difficulties of expanding globally? How can each of these difficulties create
negative effects on the operating performance of FIs?

First, the difficulties of international expansion include the higher cost of information collection
and monitoring in many countries. Because the level of customer specific information may not
be as readily available as in the U.S., the absolute level of lending risk may be higher. Also,
coordinating different regulatory rules and guidelines will increase the cost of regulation.
Second, the political risk of nationalization or expropriation may increase the costs to an FI from
the loss of fixed assets to the legal recovery of deposits in U.S. courts from such action. Third,
the establishment of foreign offices may have large fixed costs.

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Chapter Twenty Four
Futures and Forwards
Chapter Outline

Introduction

Forward and Futures Contracts


Spot Contracts
Forward Contracts
Futures Contracts

Forward Contracts and Hedging Interest Rate Risk

Hedging Interest Rate Risk with Futures Contracts


Microhedging
Macrohedging
Routine Hedging versus Selective Hedging
Macrohedging with Futures
The Problem of Basis Risk

Hedging Foreign Exchange Risk


Forwards
Futures
Estimating the Hedge Ratio

Hedging Credit Risk with Futures and Forwards


Credit Forward Contracts and Credit Risk Hedging
Futures Contracts and Catastrophe Risk
Futures and Forward Policies of Regulators

Summary

277
Solutions for End-of-Chapter Questions and Problems: Chapter Twenty Four

1. What are derivative contracts? What is the value of derivative contracts to the managers of
FIs? Which type of derivative contracts had the highest volume among all U.S. banks as of
September 2003?

Derivatives are financial assets whose value is determined by the value of some underlying asset.
As such, derivative contracts are instruments that provide the opportunity to take some action at
a later date based on an agreement to do so at the current time. Although the contracts differ, the
price, timing, and extent of the later actions usually are agreed upon at the time the contracts are
arranged. Normally the contracts depend on the activity of some underlying asset.

The contracts have value to the managers of FIs because of their aid in managing the various
types of risk prevalent in the institutions. As of September 2003 the largest category of
derivatives in use by commercial banks was swaps, which was followed by options, and then by
futures and forwards.

2. What has been the regulatory result of some of the misuses by FIs of derivative products?

In many cases the accounting requirements for the use of derivative contracts have been
tightened. Specifically, FASB now requires that all derivatives be marked to market and that all
gains and losses immediately be identified on financial statements.

3. What are some of the major differences between futures and forward contracts? How do
these contracts differ from a spot contract?

A spot contract is an exchange of cash, or immediate payment, for financial assets, or any other
type of assets, at the time the agreement to transact business is made, i.e., at time 0. Futures and
forward contracts both are agreements between a buyer and a seller at time 0 to exchange the
asset for cash (or some other type of payment) at a later time in the future. The specific grade
and quantity of asset is identified, as is the specific price and time of transaction.

One of the differences between futures and forward contracts is the uniqueness of forward
contracts because they are negotiated between two parties. On the other hand, futures contracts
are standardized because they are offered by and traded on an exchange. Futures contracts are
marked to market daily by the exchange, and the exchange guarantees the performance of the
contract to both parties. Thus the risk of default by the either party is minimized from the
viewpoint of the other party. No such guarantee exists for a forward contract. Finally, delivery
of the asset almost always occurs for forward contracts, but seldom occurs for futures contracts.
Instead, an offsetting or reverse transaction occurs through the exchange prior to the maturity of
the contract.

4. What is a naive hedge? How does a nave hedge protect the FI from risk?

A hedge involves protecting the price of or return on an asset from adverse changes in price or
return in the market. A naive hedge usually involves the use of a derivative instrument that has

278
the same underlying asset as the asset being hedged. Thus if a change in the price of the cash
asset results in a gain, the same change in market value will cause the derivative instrument to
generate a loss that will offset the gain in the cash asset.

5. An FI holds a 15-year, par value, $10,000,000 bond that is priced at 104 with a yield to
maturity of 7 percent. The bond has a duration of eight years, and the FI plans to sell it
after two months. The FIs market analyst predicts that interest rates will be 8 percent at
the time of the desired sale. Because most other analysts are predicting no change in rates,
two-month forward contracts for 15-year bonds are available at 104. The FI would like to
hedge against the expected change in interest rates with an appropriate position in a
forward contract. What will be this position? Show that if rates rise 1 percent as forecast,
the hedge will protect the FI from loss.

The expected change in the spot position is 8 x $10,400,000 x (1/1.07) = -$777,570. This
would mean a price change from 104 to 96.2243 per $100 face value of bonds. By entering into
a two-month forward contract to sell $10,000,000 of 15-year bonds at 104, the FI will have
hedged its spot position. If rates rise by 1 percent, and the bond value falls by $777,570, the FI
can close out its forward position by receiving 104 for bonds that are now worth 96.2243 per
$100 face value. The profit on the forward position will offset the loss in the spot market.

The actual transaction to close the forward contract may involve buying the bonds in the market
at 96.2243 and selling the bonds to the counterparty at 104 under the terms of the forward
contract. Note that if a futures contract were used, closing the hedge position would involve
buying a futures contract through the exchange with the same maturity date and dollar amount as
the initial opening hedge contract.

6. Contrast the position of being short with that of being long in futures contracts.

To be short in futures contracts means that you have agreed to sell the underlying asset at a
future time, while being long means that you have agreed to buy the asset at a later time. In each
case, the price and the time of the future transaction are agreed upon when the contracts are
initially negotiated.

7. Suppose an FI purchases a Treasury bond futures contract at 95.

a. What is the FIs obligation at the time the futures contract was purchased?

You are obligated to take delivery of a $100,000 face value 20-year Treasury bond at a
price of $95,000 at some predetermined later date.

b. If an FI purchases this contract, in what kind of hedge is it engaged?

This is a long hedge undertaken to protect the FI from falling interest rates.

c. Assume that the Treasury bond futures price falls to 94. What is the loss or gain?

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The FI will lose $1,000 since the FI must pay $95,000 for bonds that have a market value
of only $94,000.

d. Assume that the Treasury bond futures price rises to 97. Mark-to-market the position.

In this case the FI gains $2,000 since the FI pays only $95,000 for bonds that have a market
value of $97,000.

8. Long Bank has assets that consist mostly of 30-year mortgages and liabilities that are short-
term time and demand deposits. Will an interest rate futures contract the bank buys add to
or subtract from the banks risk?

The purchase of an interest rate futures contract will add to the risk of the bank. If rates increase
in the market, the value of the banks assets will decrease more than the value of the liabilities.
In addition, the value of the futures contract also will decrease. Thus the bank will suffer
decreases in value both on and off the balance sheet. If the bank had sold the futures contract,
the increase in rates would have allowed the futures position to reflect a gain that would offset
(at least partially) the losses in value on the balance sheet.

9. In each of the following cases, indicate whether it would be appropriate for an FI to buy or
sell a forward contract to hedge the appropriate risk.

a. A commercial bank plans to issue CDs in three months.

The bank should sell a forward contract to protect against an increase in interest rates.

b. An insurance company plans to buy bonds in two months.

The insurance company should buy a forward contract to protect against a decrease in
interest rates.

c. A thrift is going to sell Treasury securities next month.

The thrift should sell a forward contract to protect against an increase in interest rates.

d. A U.S. bank lends to a French company; the loan is payable in francs.

The bank should sell francs forward to protect against a decrease in the value of the franc,
or an increase in the value of the dollar.

e. A finance company has assets with a duration of six years and liabilities with a duration
of 13 years.

The finance company should buy a forward contract to protect against decreasing interest
rates that would cause the value of liabilities to increase more than the value of assets, thus
causing a decrease in equity value.

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10. The duration of a 20-year, 8 percent coupon Treasury bond selling at par is 10.292 years.
The bonds interest is paid semiannually, and the bond qualifies for delivery against the
Treasury bond futures contract.

a. What is the modified duration of this bond?

The modified duration is 10.292/1.04 = 9.896 years.

b. What is the impact on the Treasury bond price if market interest rates increase 50 bps?

P = -MD(R)$100,000 = -9.896 x 0.005 x $100,000 = -$4,948.08.

c. If you sold a Treasury bond futures contract at 95 and interest rates rose 50 basis points,
what would be the change in the value of your futures position?

P = - MD( R) P = - 9.896(0.005)$95,000 = - $4,700.70

d. If you purchased the bond at par and sold the futures contract, what would be the net
value of your hedge after the increase in interest rates?

Decrease in market value of the bond purchase -$4,948.08


Gain in value from the sale of futures contract $4,700.70
Net gain or loss from hedge -$247.38

11. What are the differences between a microhedge and a macrohedge for a FI? Why is it
generally more efficient for FIs to employ a macrohedge than a series of microhedges?

A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk
exposure of a specific transaction, while a macrohedge is an attempt to hedge the duration gap of
the entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance
sheet position will find that hedging is excessively costly, because the use of a series of
microhedges ignores the FIs internal hedges that are already on the balance sheet. That is, if a
long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching
long-term fixed-rate liability position that also is exposed to interest rate decreases. Putting on
two microhedges to reduce the risk exposures of each of these positions fails to recognize that
the FI has already hedged much of its risk by taking matched balance sheet positions. The
efficiency of the macrohedge is that it focuses only on those mismatched positions that are
candidates for off-balance-sheet hedging activities.

12. What are the reasons an FI may choose to hedge selectively its portfolio?

Selective hedging involves an explicit attempt to not minimize the risk on the balance sheet. An
FI may choose to hedge selectively in an attempt to improve profit performance by accepting
some risk on the balance sheet, or to arbitrage profits between a spot assets price movements
and the price movements of the futures price. This latter situation often occurs because of
changes in basis caused in part by cross-hedging.

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13. Hedge Row Bank has the following balance sheet (in millions):

Assets $150 Liabilities $135


Equity $15
Total $150 Total $150

The duration of the assets is six years, and the duration of the liabilities is four years. The
bank is expecting interest rates to fall from 10 percent to 9 percent over the next year.

a. What is the duration gap for Hedge Row Bank?

DGAP = D A k x DL = 6 (0.9)(4) = 6 3.6 = 2.4 years

b. What is the expected change in net worth for Hedge Row Bank if the forecast is
accurate?

Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.01/1.10)$150 = $3.272.

c. What will be the effect on net worth if interest rates increase 100 basis points?

Expected E = -DGAP[R/(1 + R)]A = -2.4(0.01/1.10)$150 = -$3.272.

d. If the existing interest rate on the liabilities is 6 percent, what will be the effect on net
worth of a 1 percent increase in interest rates?

Solving for the impact on the change in equity under this assumption involves finding the
impact of the change in interest rates on each side of the balance sheet, and then
determining the difference in these values. The analysis is based on the original equation:

Expected E = A - L
A = -DA [RA /(1 + RA )]A = -6[0.01/1.10]$150 = -$8.1818
and L = -D L[RL/(1 + RL)]L = -4[0.01/1.06]$135 = -$5.0943
Therefore, E = A - L = -$8.1818 (-$5.0943) = - $3.0875.

14. For a given change in interest rates, why is the sensitivity of the price of a Treasury bond
futures contract greater than the sensitivity of the price of a Treasury bill futures contract?

The price sensitivity of a futures contract depends on the duration of the asset underlying the
contract. In the case of a T-bill contract, the duration is 0.25 years. In the case of a T-bond
contract, the duration is much longer.

15. What is the meaning of the Treasury bond futures price quote 101-13?

A bid-ask quote of 101 - 13 = $101 13/32 per $100 face value. Since the Treasury bond futures
contracts are for $100,000 face value, the quoted price is $101,406.25.

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16. What is meant by fully hedging the balance sheet of an FI?

Fully hedging the balance sheet involves using a sufficient number of futures contracts so that
any gain (or loss) of net worth on the balance sheet is just offset by the loss (or gain) from off-
balance-sheet use of futures for given changes in interest rates.

17. Tree Row Bank has assets of $150 million, liabilities of $135 million, and equity of $15
million. The asset duration is six years, and the duration of the liabilities is four years.
Market interest rates are 10 percent. Tree Row Bank wishes to hedge the balance sheet
with Treasury bond futures contracts, which currently have a price quote of $95 per $100
face value for the benchmark 20-year, 8 percent coupon bond underlying the contract.

a. Should the bank go short or long on the futures contracts to establish the correct
macrohedge?

The bank should sell futures contracts since an increase in interest rates would cause the
value of the equity and the futures contracts to decrease. But the bank could buy back the
futures contracts to realize a gain to offset the decreased value of the equity.

b. How many contracts are necessary to fully hedge the bank?

If the market value of the underlying 20-year, 8 percent benchmark bond is $95 per $100,
the market rate is 8.525 percent (using a calculator) and the duration is 10.05 as shown on
the last page of this chapter solutions. The number of contracts to hedge the bank is:

(D kD L ) A (6 (0.9)4)$150 m $360,000 ,000


NF A 377.06 contracts
D F x PF 10.05 x $95,000 $954,750

c. Verify that the change in the futures position will offset the change in the cash balance
sheet position for a change in market interest rates of plus 100 basis points and minus
50 basis points.

For an increase in rates of 100 basis points, the change in the cash balance sheet position is:
Expected E = -DGAP[R/(1 + R)]A = -2.4(0.01/1.10)$150 = -$3,272,727.27. The
change in bond value = -10.05(0.01/1.08525)$95,000 = -$8,797.51, and the change in 377
contracts is -$8,797.51 x 377 = -$3,316,662.06. Since the futures contracts were sold, they
could be repurchased for a gain of $3,316,662.06. The difference between the two values
is a net gain of $43,934.79.

For a decrease in rates of 50 basis points, the change in the cash balance sheet position is:
Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.005/1.10)$150 = $1,636,363.64. The
change in each bond value = -10.05(-0.005/1.08525)$95,000 = $4,398.76 and the change in
377 contracts is $4,398.76 x 377 = $1,658,331.03. Since the futures contracts were sold,
they could be repurchased for a loss of $1,658,331.03. The difference between the two
values is a loss of $21,967.39.

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d. If the bank had hedged with Treasury bill futures contracts that had a market value of
$98 per $100 of face value, how many futures contracts would have been necessary to
hedge fully the balance sheet?

If Treasury bill futures contracts are used, the duration of the underlying asset is 0.25 years,
the face value of the contract is $1,000,000, and the number of contracts necessary to hedge
the bank is:

( D kD L ) A (6 (0.9)4)$150 m $360,000 ,000


NF A 1,469.39 contracts
D F x PF 0.25 x $980 ,000 $245 ,000

e. What additional issues should be considered by the bank in choosing between T-bonds
or T-bills futures contracts?

In cases where a large number of Treasury bonds are necessary to hedge the balance sheet
with a macrohedge, the FI may need to consider whether a sufficient number of deliverable
Treasury bonds are available. Although the number of Treasury bill contracts necessary to
hedge the balance sheet is greater than the number of Treasury bonds, the bill market is
much deeper and the availability of sufficient deliverable securities should be less of a
problem.

18. Reconsider Tree Row Bank in problem 17 but assume that the cost rate on the liabilities is
6 percent.

a. How many contracts are necessary to fully hedge the bank?

In this case, the bank faces different average interest rates on both sides of the balance
sheet, and further, the yield on the bonds underlying the futures contracts is a third interest
rate. Thus the hedge also has the effects of basis risk. Determining the number of futures
contracts necessary to hedge this balance sheet must consider separately the effect of a
change in rates on each side of the balance sheet, and then consider the combined effect on
equity. Estimating the number of contracts can be determined with the modified general
equation shown on the next page.

b. Verify that the change in the futures position will offset the change in the cash balance
sheet position for a change in market interest rates of plus 100 basis points and minus
50 basis points.

For an increase in rates of 100 basis points, E = 0.01[(4/1.06)$135 m (6/1.10)$150 m] =


-$3,087,478.56. The change in the bond value is 10.05(.01/1.08525)$95,000 = -$8,797.51,
and the change for 351 contracts = -$3,087,926.74. Since the futures contracts were sold,
they could be repurchased for a gain of $3,087,926.74. The difference between the two
values is a net gain of $448.18.

For a decrease in rates of 50 basis points, E = -0.005[(4/1.06)$135 m (6/1.10)$150 m] =


$1,543,739.28. The change in the bond value is 10.05(-.005/1.08525)$95,000 =

284
$4,398.75, and the change for 351 contracts = $1,543,963.01. Since the futures contracts
were sold, they could be repurchased for a loss of $1,543,963.01. The difference between
the two values is a net loss of $223.73.

Modified Equation Model for part (a):

F E
F A L

R R R
D F ( N F * PF ) * D A * * A
D L * * L
(1 RF ) (1 RA ) (1 R L )
DL D
* R * L A * R * A
(1 RL ) (1R A )

DF ( N F * PF ) (1R F ) * ( MDL * L MD A * A)
1
N F * PF * (MD L * L MD A * A)
MD F
MD L * L MD A * A
NF
PF * MD F

MD * A MDL * L
A
PF * MDF

6 4
*150 ,000,000 *135,000 ,000
1.10 1.06
10.05
95,000 *
1.08525
$818 ,181,818.18 $509,433,962 .26

$879,751.21
$308 ,747,855.92

$879,751 .21
350.95 or 351 contracts

c. If the bank had hedged with Treasury bill futures contracts that had a market value of
$98 per $100 of face value, how many futures contracts would have been necessary to
fully hedge the balance sheet?

A market value of $98 per $100 of face value implies a discount rate of 8 percent on the
underlying T-bills. Therefore the equation developed above in part (a) to determine the

285
number of contracts necessary to hedge the bank can be adjusted as follows for the use of
T-bill contracts:

MD * A MD L * L
NF A
PF * MD F
6 4
* 150,000 ,000 * 135,000,000
1 . 10 1 . 06
0.25
980 ,000 *
1.08
$818,181,818.18 $509 ,433,962.26

$226,851.85
$308,747 ,855 .92

$226 ,851 .85
1,361.01or 1,361 contracts

19. What is basis risk? What are the sources of basis risk?

Basis risk is the lack of perfect correlation between changes in the yields of the on-balance-sheet
assets and the changes in interest rates on the futures contracts. The reason for this difference is
that the cash assets and the futures contracts are traded in different markets.

20. How would your answers for part (b) in problem 17 change if the relationship of the price
sensitivity of futures contracts to the price sensitivity of underlying bonds were br = 0.92?

The number of contracts necessary to hedge the bank would increase to 410 contracts. This can
be found by dividing $360,000,000 by ($954,750 * 0.92).

21. A mutual fund plans to purchase $500,000 of 30-year Treasury bonds in four months.
These bonds have a duration of 12 years and are priced at 96-08\32. The mutual fund is
concerned about interest rates changing over the next four months and is considering a
hedge with T-bond futures contracts that mature in six months. The T-bond futures
contracts are selling for 98-24\32 and have a duration of 8.5 years.

a. If interest rate changes in the spot market exactly match those in the futures market,
what type of futures position should the mutual fund create?

The mutual fund needs to enter into a contract to buy Treasury bonds at 98-24 in four
months. The fund manager fears a fall in interest rates and by buying a futures contract, the
profit from a fall in rates will offset a loss in the spot market from having to pay more for
the securities.

b. How many contracts should be used?

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The number of contracts can be determined by using the following equation:
D * P 12 * $481,250
NF 6.88 contracts
D F * PF 8.5 * $98,750
Rounding this up to the nearest whole number is 7.0 contracts.

c. If the implied rate on the deliverable bond in the futures market moves 12 percent more
than the change in the discounted spot rate, how many futures contracts should be used
to hedge the portfolio?

In this case the value of br = 1.12, and the number of contracts is 6.88/1.12 = 6.14
contracts. This may be adjusted downward to 6 contracts.

d. What causes futures contracts to have different price sensitivity than the assets in the
spot markets?

One reason for the difference in price sensitivity is that the futures contracts and the cash
assets are traded in different markets.

22. Consider the following balance sheet (in millions) for an FI:

Assets Liabilities
Duration = 10 years $950 Duration = 2 years $860
Equity $90

a. What is the FI's duration gap?

The duration gap is 10 - (860/950)(2) = 8.19 years.

b. What is the FI's interest rate risk exposure?

The FI is exposed to interest rate increases. The market value of equity will decrease if
interest rates increase.

c. How can the FI use futures and forward contracts to put on a macrohedge?

The FI can hedge its interest rate risk by selling future or forward contracts.

d. What is the impact on the FI's equity value if the relative change in interest rates is an
increase of 1 percent? That is, R/(1+R) = 0.01.

E - 8.19(950,000)(.01) -$77,805

e. Suppose that the FI in part (c) macrohedges using Treasury bond futures that are
currently priced at 96. What is the impact on the FI's futures position if the relative
change in all interest rates is an increase of 1 percent? That is, R/(1+R) = 0.01.
Assume that the deliverable Treasury bond has a duration of nine years.

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E - 9(96,000)(.01) -$8,640 per futures contract. Since the macrohedge is a short hedge,
this will be a profit of $8,640 per contract.

f. If the FI wanted a perfect macrohedge, how many Treasury bond futures contracts does
it need?

To perfectly hedge, the Treasury bond futures position should yield a profit equal to the
loss in equity value (for any given increase in interest rates). Thus, the number of futures
contracts must be sufficient to offset the $77,805 loss in equity value. This will necessitate
the sale of $77,805/8,640 = 9.005 contracts. Rounding down, to construct a perfect
macrohedge requires the FI to sell 9 Treasury bond futures contracts.

23. Refer again to problem 22. How does consideration of basis risk change your answers to
problem 22?

In problem 22, we assumed that basis risk did not exist. That allowed us to assert that the
percentage change in interest rates (R/(1+R)) would be the same for both the futures and
underlying cash positions. If there is basis risk, then (R/(1+R)) is not necessarily equal to
(Rf /(1+Rf )). If the FI wants to fully hedge its interest rate risk exposure in an environment with
basis risk, the required number of futures contracts must reflect the disparity in volatilities
between the futures and cash markets.

a. Compute the number of futures contracts required to construct a perfect macrohedge if


[Rf /(1+Rf ) R/(1+R)] = br = 0.90

( D A - k D L ) A 8.19(950,000)
If br = 0.9, then: N f = = = 10 contracts
DF P F b (9)(96,000 )(.90)

b. Explain what is meant by br = 0.90.

br = 0.90 means that the implied rate on the deliverable bond in the futures market moves
by 0.9 percent for every 1 percent change in discounted spot rates (R/(1+R)).

c. If br = 0.90, what information does this provide on the number of futures contracts
needed to construct a perfect macrohedge?

If br = 0.9 then the percentage change in cash market rates exceeds the percentage change
in futures market rates. Since futures prices are less sensitive to interest rate shocks than
cash prices, the FI must use more futures contracts to generate sufficient cash flows to
offset the cash flows on its balance sheet position.

24. An FI is planning to hedge its $100 million bond instruments with a cross hedge using
Euromark interest rate futures. How would the FI estimate

br = [Rf/(1+R f) R/(1+R)]

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to determine the exact number of Euromark futures contracts to hedge?

One way of estimating br (or the ratio of changes in yields of futures to the underlying rates)
involves regressing the changes in bond yields against Euromark futures. The estimated slope of
the line br provides the exact number of contracts to hedge. Note that historical estimation of the
basis is not a guarantee that it will remain the same in the future.

25. Village Bank has $240 million of assets with a duration of 14 years and liabilities worth
$210 million with a duration of 4 years. In the interest of hedging interest rate risk, Village
Bank is contemplating a macrohedge with interest rate futures contracts now selling for
102-21\32. If the spot and futures interest rates move together, how many futures contracts
must Village Bank sell to fully hedge the balance sheet?

( D kD L ) A (14 (0..875)4)$240m
NF A 272.75 or 273 contracts
D F x PF 9 x $102,656

26. Assume an FI has assets of $250 million and liabilities of $200 million. The duration of the
assets is six years, and the duration of the liabilities is three years. The price of the futures
contract is $115,000, and its duration is 5.5 years.

a. What number of futures contracts is needed to construct a perfect hedge if br = 1.10?

( D A - k D L )A [6 (3 * 0.8)]$ 250,000,000 $900 ,000,000


N f= 1,293.57 contracts
( D f P f b) 5.5 * $115,000 * 1.10 $695,750

b. If Rf/(1+Rf) = 0.0990, what is the expected R/(1+R)?

R/(1 + R) = (Rf/(1+R f))/br = 0.0990/1.10 = 0.09

27. Suppose an FI purchases a $1 million 91-day Eurodollar futures contract trading at 98.50.

a. If the contract is reversed two days later by purchasing the contract at 98.60, what is the
net profit?

Profit = 0.9860 - 0.9850 x 91/360 x 1,000,000 = $252.78

b. What is the loss or gain if the price at reversal is 98.40?


Loss = 0.9840 - 0.9850 x 91/360 x 1,000,000 = -$252.78

28. What factors may make the use of swaps or forward contracts preferable to the use of
futures contracts for the purpose of hedging long-term foreign exchange positions?

A primary factor is that futures contracts may not be available on the day the hedge is desired, or
the desired maturity may not be available. If the maturity of the available contract is less than
the desired hedge maturity, the FI will incur additional transaction costs from rolling the futures

289
contract to meet the desired hedge maturity. Such action incurs additional uncertainty about the
price of the contracts in the future.

29. An FI has an asset investment in euros. The FI expects the exchange rate of $/to increase
by the maturity of the asset.

a. Is the dollar appreciating or depreciating against the euro?

The dollar is depreciating as it will take more dollars per in the future.

b. To fully hedge the investment, should the FI buy or sell euro futures contracts?

The FI should buy futures.

c. If there is perfect correlation between changes in the spot and futures contracts, how
should the FI determine the number of contracts necessary to hedge the investment
fully?

A sufficient number of futures contracts should be purchased so that a loss (profit) on the
futures position will just offset a profit (loss) on the cash loan portfolio. If there is perfect
correlation between the spot and futures prices, the number of futures contracts can be
determined by dividing the value of the foreign currency asset portfolio by the foreign
currency size of each contract. If the spot and futures prices are not perfectly correlated,
the value of the long asset position at maturity must be adjusted by the hedge ratio before
dividing by the size of the futures contract.

30. What is meant by tailing the hedge? What factors allow an FI manager to tail the hedge
effectively?

Gains from futures contract positions typically are received throughout the life of the hedge from
the process of marking-to-market the futures position. These gains can be reinvested to generate
interest income cash flows that reduce the number of futures contracts needed to hedge an
original cash position. Higher short-term interest rates and less uncertainty in the pattern of
expected cash flows from marking-to-market the futures position will increase the effectiveness
of this process.

31. What does the hedge ratio measure? Under what conditions is this ratio valuable in
determining the number of futures contracts necessary to hedge fully an investment in
another currency? How is the hedge ratio related to basis risk?

The hedge ratio measures the relative sensitivity of futures prices to changes in the spot
exchange rates. This ratio is particularly helpful when the changes in futures prices are not
perfectly correlated with the changes in the spot exchange rates. The hedge ratio is a measure of
the basis risk between the futures and spot exchange rates.

290
32. What technique is commonly used to estimate the hedge ratio? What statistical measure is
an indicator of the confidence that should be placed in the estimated hedge ratio? What is
the interpretation if the estimated hedge ratio is greater than one? Less than one?

A common method to estimate the hedge ratio is to regress recent changes in spot prices on
recent changes in futures prices. The degree of confidence is measured by the value of R2 for the
regression. A value of R2 equal to one implies perfect correlation between the two price
variables. The estimated slope coefficient () from the regression equation is the estimated hedge
ratio or measure of sensitivity between spot prices and futures prices. A value of greater than
one means that changes in spot prices are greater than changes in futures prices, and the number
of futures contracts must be increased accordingly. A value of less than one means that
changes in spot prices are less than changes in futures prices, and the number of futures contracts
can be decreased accordingly.

33. An FI has assets denominated in British pound sterling of $125 million and sterling
liabilities of $100 million.

a. What is the FI's net exposure?

The net exposure is $125 million - $100 million = $25 million.

b. Is the FI exposed to a dollar appreciation or depreciation?

The FI is exposed to dollar appreciation, or declines in the pound relative to the dollar.

c. How can the FI use futures or forward contracts to hedge its FX rate risk?

The FI can hedge its FX rate risk by selling forward or futures contracts in pound sterling,
assuming the contracts are quoted as $/, that is, in direct quote terms in the U.S.

d. What is the number of futures contracts to be utilized to hedge fully the FI's currency
risk exposure?

Assuming that the contract size for British pounds is 62,500, the FI must sell Nf = $25
million/62,500 = 400 pound sterling futures contracts.

e. If the British pound falls from $1.60/ to $1.50/, what will be the impact on the FI's
cash position?

The cash position will witness a loss if the pound sterling depreciated in terms of the U.S.
dollar. The loss would be equal to the net exposure (in $) multiplied by the FX rate shock
(St) = $5 million ($1.50 - $1.60) = -$2.5 million.

f. If the British pound futures price falls from $1.55/ to $1.45/, what will be the impact
on the FI's futures position?

291
The gain on the short futures hedge is:

Nf x 62,500 x f t = -400($62,500)($1.45 - $1.55) = +$2.5 million

g. Using the information in parts (e) and (f ), what can you conclude about basis risk?

In cases where basis risk does not occur, such as in this problem, a perfect hedge is
possible. In other words, in this case the hedge ratio = 1.0.

34. Refer to problem 33, part (f).

a. If the British pound futures price fell from $1.55/ to $1.43/, what would be the
impact on the FI's futures position?

The gain on the short futures hedge is:

Nf x 62,500 x f t = -400($62,500)($1.43 - $1.55) = +$3.0 million

b. Does your answer to part (a) differ from your answer to part (f) in problem 33? Why
or why not?

Yes. Since St ft , there is basis risk in the foreign exchange market. Since futures FX
rates are more volatile than cash FX rates, the gain in the futures market exceeded the loss
in the cash market.

c. How would you fully hedge the FX rate risk exposure in problem 33 using the new
futures price change?

A perfect hedge can be constructed using fewer pound sterling futures contracts. Since h =
St/f t = 0.10/0.12 = 0.833, the number of futures contracts sold to fully hedge the FX rate
risk exposure is Nf = $25 million (.833)/$62,500 = 333.2 contracts. The gain in the futures
hedge then will be -Nf x $62,500 x ft = -333.2($62,500)($1.43 - $1.55) = +$2.5 million

35. An FI is planning to hedge its one-year $100 million Swiss franc (SF)-denominated loan
against exchange rate risk. The current spot rate is $0.60/SF. A 1-year SF futures contract
is currently trading at $0.58/SF. SF futures are sold in standardized units of SF125,000.

a. Should the FI be worried about the SF appreciating or depreciating?

The FI should be worried about the SF depreciation because it will provide fewer dollars
per SF.

b. Should it buy or sell futures to hedge against exchange rate exposure?

The FI should sell SF futures contracts to hedge this exposure.

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c. How many futures contracts should it buy or sell if a regression of past spot prices on
future prices generates an estimated slope of 1.4?

Nf = (Long asset position x br


/(Futures contract size) = $100m x 1.4/SF125,000 = 1,120
contracts

d. Show exactly how the FI is hedged if it repatriates its principal of SF100 million at
year-end, the spot price of SF at year-end is $0.55/SF, and the forward price is
$0.5443/SF.

The original loan in dollars = SF100 x $0.60 = $60 million, and the loan value in dollars at
year-end = SF100 x $0.55 = $55 million. The balance sheet has decreased in value by
$5,000,000. The gain from hedge = ($0.58 - $0.5443) x SF125,000 x 1,120 = $4,998,000.

36. An FI has made a loan commitment of SF10 million that is likely to be taken down in six
months. The current spot rate is $0.60/SF.

a. Is the FI exposed to the dollars depreciating or appreciating? Why?

The FI is exposed to the dollar depreciating, because it would require more dollars to
purchase the SF10 million if the loan is drawn down as expected.

b. If the spot rate six months from today is $0.64/SF, what amount of dollars is needed if
the loan is taken down and the FI is unhedged?

The FI needs $0.64 x SF10 million = $6.4 million to make the SF-denominated loan.

c. If it decides to hedge using SF futures, should the FI buy or sell SF futures?

The FI should buy SF futures if it decides to hedge against the depreciation of the dollar.

d. A six-month SF futures contract is available for $0.61/SF. What net amount would be
needed to fund the loan at the end of six months if the FI had hedged using the SF10
million futures contract? Assume that futures prices are equal to spot prices at the time
of payment (i.e., at maturity).

If it has hedged using futures, the FI will gain ($0.64-$0.61)* SF10 million = $300,000 on
its futures position. Thus the net payment will be $6.1 million.

37. A U.S. FI has assets denominated in Swiss francs (SF) of 75 million and liabilities of 125
million. The spot rate is $0.6667/SF, and one-year futures are available for $0.6579/SF.

a. What is the FIs net exposure?

The net exposure is SF50 million.

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b. Is the FI exposed to dollar appreciation or depreciation?

The FI is exposed to depreciation of the dollar. If the dollar weakens, the FI will need to
pay more dollars to cover its SF liabilities than it will receive for its assets.

c. If the SF spot rate falls from $0.6667/SF to $0.6897/SF, how will this impact the FIs
currency exposure? Assume no hedging.

The loss would be SF50,000,000($0.6667-$0.6897) = -$1,150,000.

d. What is the number of futures contracts necessary to fully hedge the currency risk
exposure of the FI? The contract size is SF125,000 per contract.

The number of contracts = SF50,000,000/SF125,000 = 400 contracts.

e. If the SF futures price falls from $0.6579/SF to $0.6349/SF, what will be the impact on
the FIs futures position?

The gain on the futures position would be 400 contracts*SF125,000*($0.6579 - $0.6349) =


+$1,150,000.

38. What is a credit forward? How is it structured?

A credit forward is a forward agreement that hedges against an increase in default risk on a loan.
The credit forward specifies a credit spread on a benchmark bond issued by a bank borrower.
The credit spread measures a risk premium above the risk free rate to compensate for default
risk.

39. What is the gain on the purchase of a $20,000,000 credit forward contract with a modified
duration of seven years if the credit spread between a benchmark Treasury bond and a
borrowing firms debt decreases by 50 basis points?

The gain would be MD(R)$20 million = 7*0.005*$20 million = $700,000.

40. How is selling a credit forward similar to buying a put option?

After the loan is made, the FI sells a credit forward. If the credit risk of the borrower decreases
sufficiently that the spread over the benchmark bond increases, the forward seller (FI) will
realize a gain at the maturity of the forward contract that will offset the decrease in value of the
loan. Thus the bank benefits as the credit risk of the borrower decreases. This is the exact same
situation of a put option buyer when the stock price goes down.

If the credit risk improves, the lender bank will pay the forward buyer because the benchmark
spread will have decreased. However, since the spread can only decrease to zero, the FI has
limited loss exposure. This is similar to paying a premium on a put option.

294
41. A property-casualty (PC) insurance company has purchased catastrophe futures contracts to
hedge against loss during the hurricane season. At the time of purchase, the market
expected a loss ratio of 0.75. After processing claims from a severe hurricane, the PC
actually incurred a loss ratio of 1.35. What amount of profit did the PC make on each
$25,000 futures contract?

The payoff = actual loss ratio x $25,000 = 1.35 x $25,000 = $33,750.

42. What is the primary goal of regulators in regard to the use of futures by FIs? What
guidelines have regulators given banks for trading in futures and forwards?

Regulators of banks have encouraged the use of futures for hedging and have discouraged the
use of futures for speculation. Banks are required to (1) establish internal guidelines regarding
hedging activity, (2) establish trading limits, and (3) disclose large contract positions that
materially affect bank risk to shareholders and outside investors. Finally, FASB requires all
firms to reflect mark-to-market value of their derivative positions in their financial statements.

295
Calculation of Duration for Problems 17 and 18
$1,000 bond, 8% coupon, R = 8.525% and R = 8.2052%, n = 20 years (40 period)
Cash Price = $95 Price = $98
Time Flow PVIF8.525% t*CF*PVIF CF*PVIF PVIF8.2052% t*CF*PVIF
1 40 0.959117 38.36468 38.36468 0.960591 38.42364
2 40 0.919905 73.59243 36.79621 0.922735 73.81879
3 40 0.882297 105.87562 35.29187 0.886371 106.36449
4 40 0.846226 135.39614 33.84903 0.851440 136.23034
5 40 0.811630 162.32592 32.46518 0.817885 163.57703
6 40 0.778448 186.82745 31.13791 0.785653 188.55673
7 40 0.746622 209.05427 29.86490 0.754691 211.31352
8 40 0.716098 229.15143 28.64393 0.724949 231.98382
9 40 0.686822 247.25590 27.47288 0.696380 250.69674
10 40 0.658743 263.49704 26.34970 0.668936 267.57445
11 40 0.631811 277.99693 25.27245 0.642574 282.73254
12 40 0.605981 290.87080 24.23923 0.617251 296.28033
13 40 0.581207 302.22738 23.24826 0.592925 308.32120
14 40 0.557445 312.16921 22.29780 0.569559 318.95289
15 40 0.534655 320.79299 21.38620 0.547113 328.26776
16 40 0.512797 328.18986 20.51187 0.525552 336.35309
17 40 0.491832 334.44574 19.67328 0.504840 343.29132
18 40 0.471724 339.64156 18.86898 0.484945 349.16031
19 40 0.452439 343.85354 18.09755 0.465834 354.03356
20 40 0.433942 347.15344 17.35767 0.447476 357.98044
21 40 0.416201 349.60879 16.64804 0.429841 361.06639
22 40 0.399185 351.28314 15.96742 0.412901 363.35313
23 40 0.382865 352.23624 15.31462 0.396629 364.89888
24 40 0.367213 352.52426 14.68851 0.380998 365.75848
25 40 0.352200 352.20000 14.08800 0.365984 365.98361
26 40 0.337801 351.31304 13.51204 0.351561 365.62294
27 40 0.323991 349.90992 12.95963 0.337706 364.72230
28 40 0.310745 348.03434 12.42980 0.324397 363.32481
29 40 0.298041 345.72727 11.92163 0.311613 361.47102
30 40 0.285856 343.02713 11.43424 0.299333 359.19907
31 40 0.274169 339.96991 10.96677 0.287536 356.54480
32 40 0.262960 336.58933 10.51842 0.276205 353.54188
33 40 0.252210 332.91693 10.08839 0.265320 350.22189
34 40 0.241899 328.98222 9.67595 0.254864 346.61450
35 40 0.232009 324.81280 9.28037 0.244820 342.74752
36 40 0.222524 320.43442 8.90096 0.235172 338.64701
37 40 0.213426 315.87115 8.53706 0.225904 334.33738
38 40 0.204701 311.14542 8.18804 0.217001 329.84148
39 40 0.196332 306.27813 7.85329 0.208449 325.18069
40 1040 0.188305 7833.5081 195.83770 0.200234 8329.7496
Total 19095.055 950.00044 19986.740
Total/2 = 9547.5275 9993.3702
Duration = 10.050 Duration = 10.197

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