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?

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

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

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

c. What is the maturity gap for Gunnison?

MGAP = 8.31- 3.17 = 5.14 years

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 Insurance’s 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*PVIFA_i=7%,n=2 + 175*PVIF_i=7%,n=2 = $168.67

Munis: PV = 14.85*PVIFA_i=11%,n=15 + 165*PVIF_i=11%,n=15 = $141.27

Commercial Paper: PV = 6.075*PVIFA_i=6.5%,n=1 + 135*PVIF_i=6.5%,n=1 = $132.46

Note: PV = 12.80*PVIFA_i=10%,n=5 + 160*PVIF_i=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 Gunnison’s 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

* 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 model’s 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?

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 ½ year $40,000 Interest received in ½ 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 ½ year $50,000 Interest received in ½ 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 ½ year $30,000 Interest received in ½ 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.

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(r_i)] = (1 + R_i)ⁱ  (1 + R_i-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.

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