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NII = funding gap x rate change = -95 million x 0.5% = -$0.475 million
Therefore, net interest income will fall by $475,000 over the next 30 days.
Q. Financial Institution XY has assets of $1 million invested in a 30-year, 10 per
cent semi-annual 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, two-year, 7.25 per cent semi-annual coupon capital note
selling at par.
What is the leverage adjusted duration gap of Financial Institution XY?
Leverage-adjusted duration gap = DA kDL
DA = 9.94 years. We need to calculate D L and k.
DL = PV of CF @t / PV of CF
The capital note (liabilities) is selling at par = $900,000. Selling at par means
the note is trading at its face value = $900,000. Hence, the coupon rate
= current market yield (discount factor)
Coupon Rate = 7.25%, payable semi-annually --> this is the same as 3.625%
every 6 months
Therefore, 3.625% is our semi-annual coupon rate AND our semi-annual
market yield or discount factor --> it is very important that we discount
CF @ semi-annual rates because it has to be the same measurement as
the time periods otherwise we get the wrong answer)
P = $161 666.67
This means if interest rates increase from 8-10%, this means the bond value
will fall by $161,666.67. This drop in bond value can be directly hedged by
selling a 3 month forward contract at a forward price of $970,000. How does
this work? Well, look at the table below!
Time
Period
Now
(Current Market
Value of
$970,000)
In 3 months
(Current Market
Value of
$808,333)
Payments
Seller (YOU) agrees to sell a 20-year $1 million face value
bond in 3 months time for $970,000
Buyer (SOMEONE ELSE) agrees to buy a 20-year $1 million
face value bond in 3 months for $970,000
Seller (YOU) goes into the open market and purchases a 20year $1 million face value bond for $808,333 current
market price. Then you go and sell it to the buyer for the
agreed price of $970,000 (profit of $161,666.67)
Buyer (SOMEONE ELSE) buys the 20-year $1 million face
value bond for $970,000 (loss of $161,666.67)
Essentially, two things have happened: the bond you held in your portfolio
has experienced a drop in value of $161,666.67. However, you made a profit
on your forward contract ($161,666.67), so the forward contract has exactly
offset/hedged the drop in the value of your bond (that is held in your
portfolio) it has effectively offset the loss exposure!
b) From (a), we note the FI has a positive duration gap so it is exposed to interest
rate increases. Now what does this mean for the FI? An increase in interest rates
means that the firms market value of equity will decrease. So, the FI will want to
offset this decrease by macrohedging its balance sheet the FI will sell (go
short on) forward or futures contracts. Why? Because the FI will make a profit on
the forward contracts if the value of the contracts go down i.e. buy the forward
contract, lock in the price if the price goes down, then you can sell it at the
higher agreed price.
c) If interest rates increase by 1%, the firms equity value will change
by:
E = - D x A x R / (1 + R) = - 8.19 x $950,000 x +0.01 = -$77,805. An
increase in interest rates by 1% will decrease firm equity by $77,805.
To macrohedge the firms balance sheet, the FI must sell futures contracts that
will offset the decrease in equity. With a 1% increase in interest rates, the firms
futures position will fall by: F = - D x F x R / (1 + R) = -9 x 96,000 x 0.01
= -$8,640 per futures contract.
Note: The 96,000 is the value of one futures contract. For treasury
notes, one futures contract covers 1000 bonds, so if each bond trades
at $96, then one futures contract = $96,000. So if interest rates increase by
1%, the firms futures position will fall by $8,640 per contract. However, since
this macrohedge is a short hedge meaning that, since the firm has sold
futures contracts and locked in the forward price - this will offset the fall in value
by $8,640 per contract
To fully hedge a 1% increase, 77,805/8,640 = 9.005 futures contracts or
10 contracts.
Q: An FI is planning the purchase of a $5 million loan to raise the existing
average duration of its assets from 3.5 years to 5 years. It currently has total
assets worth $20 million, $5 million in cash (0 duration) and $15 million in loans.
All the loans are fairly priced.
a) Assuming it uses the cash to purchase the loan, should it purchase the loan if
its duration is seven years?
The duration of the existing loan is: 0 + $15m/$20m (X) = 3.5 years
Existing loan duration = 4.667 years
If it purchases $5 million of loans with an average duration of 7 years, its
portfolio duration will increase to $5m/$20m (7) + $15m/$20m (4.667) = 5.25
years.
In this case, the average duration will be above 5 years (of its liabilities). The FI
may be better off seeking another loan with a slightly lower duration.
b) What asset duration loans should it purchase in order to raise its average
duration to five years? The FI should seek to purchase a loan of the following
duration: $5m/$20m(X) + $15m/$20m (4.667 years) = 5 years X = duration =
6 years.
The Risk Metrics model: Fixed Income Securities
Market risk measures the estimated potential loss under adverse
circumstances.
For less well diversified FIs, the effect of unsystematic risk on the value of the
trading position would need to be added.
)=
Assume:
1 P1 = 0.04 = marginal default probability in year 1.
1 P2 = 0.06 = marginal default probability in year 2.
The risk of the loan reflects the volatility of the loans default rate (D) around its
expected value times the amount loss given default (LGD). The product of the
volatility of the default rate and the LGD is called the unexpected loss on the
loan (UL) and is a measure of the loans risk. To measure the volatility of the
default rate, assume the loan can either default or repay (that is, not default),
then the defaults are binomially distributed and the standard deviation of the
default rate for the ith borrower (D) is
Net Exposure of a FI
Net exposure of an FI = (FX Assetsi FX liabilitiesi) + (FX boughti FX soldi)
= Net foreign assetsi + Net FX boughti
Net long in a currency: asset holding > liabilities in that currency
Net short in a currency: asset holding < liabilities in that currency
FX exposure = Dollar loss/gain in currency i = Net exposure in foreign
currency i measured in Australian dollars x shock (volatility) to the $/foreign
currency i exchange rate
Tutorial 9: Sovereign risk
Ch12Q17. Chase Bank holds a $200 million loan to Argentina. The loans are
being traded at bid-offer (buy/sell) prices of 9193 per 100 in the London
secondary market.
Note: this means someone else will BUY the loan from you for $0.91 and will
SELL the loan to you for $0.93. We only look at the $0.91 value, since we (the
bank) are the owner of the $200m loan.
(a) If Chase has an opportunity to sell this loan to an investment bank at a 7 per
cent discount, what are the savings after taxes compared to selling the loan in
the secondary market? Assume the tax rate is 40 per cent.
Sell to investment bank:
Sell in secondary market:
Amount received = $200m x (1 0.07) = Amount received = 0.91 x $200m =
$186m
$182m
Tax loss benefit = ($200m $186m) x
Tax loss benefit = ($200m $182m) x
0.40 = $5.6m
0.40 = $7.2m
Net price received = $186m + $5.6m =
Net price received = $182m + $7.2m =
$191.6m
$189.2m
So selling to an investment bank would generate an extra $2.4m
(b) The investment bank in turn sells the debt at a 6 per cent 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 $186m.
It sells the loans for $200m x (1 0.06) = $188m
The profit before taxes is $188m - $186m = $2m
The tax rate is 40%, so the profit after taxes is $1.2m
(c) The real estate company converts this loan into pesos under a debt-equity
swap organised by the Argentinean Government. The official rate for dollar to
peso conversion is P1.05/$1. The free market rate is P1.10/$1. 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 (if they did not buy the loans), it
would have received $200m 1.10 = 220 million pesos. By purchasing through
the debt-equity swap, the company pays $188 million and receives $200m
1.05 = 210 million pesos, for an equivalent rate of 210/188 = P1.117/$1. Thus,
it still saves by purchasing through the debt-for-equity swap
(P1.117/$1 > P1.10/$1).
(d) How much would Chase benefit from doing a local currency debt-equity swap
itself? Why doesn't the bank do this swap?
Assuming the bank could convert the loan at $118 million into pesos at
P1.05/$1, the after tax effect would be $188 million plus the tax loss benefit,
which equals:
$188m + ($200m - $188m) x 0.40 = $192.8 million
The actual benefit was $191.6 million, the net price from part (a). So the bank
would gain $1.2 million. However, the bank doesnt do this swap because the
Federal Reserve Regulation K does not allow Chase to participate in debt-equity
purchases in other countries. Chase is also not allowed to engage in commerce
in other countries. Furthermore, a long term pesos denominated position on the
balance sheet may create more credit, liquidity, and foreign exchange risk
problems than the benefits are worth.
Ch13Q30. An FI has assets denominated in UK pound sterling of AUD$125
million and sterling liabilities of AUD$100 million.
(a) What is the FI's net exposure?
The net exposure is $125 million - $100 million = $25 million
(b) Is the FI exposed to an A$ appreciation or depreciation?
The financial institution is exposed to an appreciation in AUD, or declines in
the value of the pounds sterling relative to the AUD.
(c) How can the FI use futures or forward contracts to hedge its FX rate risk?
The financial institution can hedge its FX rate risk by selling forward contracts
in pound sterling, assuming the contracts are quoted as AUD/STG.
(d) What is the number of futures contracts to be utilised to hedge fully the FI's
currency risk exposure?
Assuming that the contract size for STG is 62,500, the FI must sell:
Nf = 25,000,000 / 62,500 = 400 pound sterling future 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 see a loss if the STG depreciated in terms of the
USD. The loss will be equal to the net exposure (in AUD) multiplied by
the FX rate shock S.
AUD 25 million x (1.50 1.60) = 25 x -0.1 = -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?
The gain on the short futures hedge is: Nf x 62,500 x ft = -400 x
(62,500) x (1.45 1.55) = +2.5 million
Liquidity index
P*1 = 1.00
W1 = 0.4
P2 = 0.82
W2 = 0.6
should be increased to $89 ($45 + $44). Thus, the fee per-cheque should be
raised to $89/(75 12) = $0.0989 per cheque.
(a) What are the risk-adjusted on-balance-sheet assets of the bank as defined
under the Basel II?
Risk-adjusted assets:
Cash 0 20 = $0
Interbank deposits 0.20 25 = $5
Mortgage loans 0.50 70 = $35
Business loans 1.00 70 = $70
Total risk-adjusted on-balance sheet assets = $110 = $110
(b) What is the total capital required for both off- and on-balance-sheet assets?
Assumption risk weight 100%
Standby LCs: $30 0.50 1.00 = $15 = $15
Foreign exchange contracts:
Potential exposure $40 0.05 = $2
Current exposure in the money = $1 = $3 1.00 = $3
Interest rate swaps:
Potential exposure $300 0.015 = $4.5
Current exposure out of the money = $0 = $4.5 1.00 = $4.5
Total risk-adjusted on- and off-balance-sheet assets = $132.5 0.08
Total minimum capital required = $10.66