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

Chapter 7:

1.

1, 2, 3 (2, was not assigned)

A financial institution has the following balance sheet structure:

Assets
Cash
Bond
Total Assets

Liabilities and Equity

Certificate of Deposit
Equity
Total Liabilities and Equity

$2,000
$10,000
$12,000

$10,000
$2,000
$12,000

The bond has a ten-year maturity and a fixed-rate coupon of 10 percent. The certificate of
deposit has a one-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
Interest expense
Net interest income (NII)

$1,000
600

$10,000 x 0.10
$10,000 x 0.06

$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?
Interest income
Interest expense
Net interest income (NII)

$1,000
700

$10,000 x 0.10
$10,000 x 0.07

$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 bank? (Remember
after one year, there are 9 years left; find price of bond with PMT = 1000, N = 9, FV = 10,000, R (interest rate) =
11%; find PV = $9,446.30; we are looking at a Eurobond since coupon paid annually.) (If the bond were semiannual coupon paying, the bond price would be $9447.70.) (Note: the market value of the bond falls when interest
rates rise.) Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as
dividends because the bank expects no additional asset growth.

Cash
Bond
Total assets

$2,000
$9,446
$11,446

Certificate of deposit
$10,000
Equity
$ 1,446
Total liabilities and equity $11,446

Note: market value of equity falls to $1,446 due to lower market value of the bond
How do we know that bond price will be $9,446? If the coupon rate is 10%, yield to maturity = 11%, then using our
financial calculator, N = 18 (only 9 years left), PMT = 500, I = 5.5%, FV = 10,000. Compute PV; find PV =
-9437.70

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 ($2,600) because the value of
the bond would be higher ($10,600) and the value of the CD would remain unchanged.
(Note: if you rounded to the nearest cent, instead of to the nearest dollar, the new market value of
equity would be $599.52; that answer also is considered correct.)
e. What factors have caused the change in operating performance and market value for
this firm?
(By operating performance I mean what caused the change in net interest income, look at parts a. and b.;
by market value, I mean what caused the change in market value in parts c. and d.)
For descriptions of refinancing and reinvestment risk, look at practice discussion problems 2 and 3.

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 fixedrate 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.
Question #2 was not assigned; it is just being shown here to contrast with #3.
2.
Two ten-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 ten-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 ten 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.
3.

Consider again the two bonds in problem (2). 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 situation 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.

Below are answers to some text book problems that were not assigned:
27. Six months ago, Qualitybank, LTD., issued a $100 million, one-year maturity CD
denominated in German deutsche marks (Euromark CD). On the same date, $60 million
was invested in a DM-denominated loan and $40 million was invested in a U.S. Treasury
bill. The exchange rate six months ago was DM1.7382/$. Assume no repayment of
principal, and an exchange rate today of DM1.3905/$. ($/DM was $.57 & now $.72).
(Ignore interest)
a. What is the current value of the Euromark CD principal (in DM and dollars)?
Today's principal value on the Euromark CD is DM173.82 and $125m (173.82/1.3905).
b. What is the current value of the German loan principal (in DM and dollars)?
Today's principal value on the loan is DM104.292 ($60MM x 1.7382) and $75
(104.292/1.3905).
c. What is the current value of the U.S. Treasury bill (in dollars and DM)?
Today's principal value on the U.S. Treasury bill is $40m and DM55.62 (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 DM)?
Qualitybank's loss is $10m or DM13.908.
Solution matrix for problem 27:
At Issue Date:
Dollar Transaction Values (in millions)
German
Euromark
Loan
$60
CD
$100
U.S T-bill $40
$100
$100

D-Marks Transaction Values (in millions)

German
Euromark
Loan
DM104.292 CD
DM173.82
U.S. T-bill DM69.528
DM173.82
DM173.82

Today:
Dollar Transaction Values (in millions)
German
Euromark
Loan
$75
CD
$125
U.S. T-bill $40
$115
$125

DM Transaction Values (in millions)

German
Euromark
Loan
DM104.292 CD
DM173.82
U.S. T-bill DM55.620
DM159.912
DM173.82

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/$. At the end of the year, the bond is downgraded to AA
and the yield increases to 10 percent. In addition, the SF appreciates to SF1.35/$.
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 80 * PVAi 8,n10 SF1,000 * PVi 8,n10 SF1,000

End of the Year

Price of Bond SF 80 * PVAi 10 ,n9 SF1,000 * PVi 10,n9 SF 884.82

The loss to the Swiss investor (SF884.82 + SF80 - SF1,000)/$1,000 = -3.52 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
= SF884.82/SF1.35 = $655.42
Interest received at end of year = SF80/SF1.35
= $59.26
Gain to U.S. investor = ($655.42 + $59.26 - $666.67)/$666.67 = +7.20%.
The U.S. investor had an equivalent loss of 3.52 percent from interest rate risk, but he had a
gain of 10.72 percent (7.20 - (-3.52)) from foreign exchange risk. If the Swiss franc had
depreciated, the loss to the U.S. investor would have been larger than 3.52 percent.
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
b. Credit risk
c. Off-balance-sheet risk
(1)
(2)
(3)
(4)

d. Technology risk
e. Foreign exchange rate risk
f. Country or sovereign risk

A bank finances a $10 million, six-year fixed-rate commercial loan by selling oneyear certificates of deposit.
a, b
An insurance company invests its policy premiums in a long-term municipal bond
portfolio.
a, b
A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to
a British entrepreneur.
b, e, f
A Japanese bank acquires an Austrian bank to facilitate clearing operations.
a, b, c, d, e, f

(5)
(6)
(7)
32.

A mutual fund completely hedges its interest rate risk exposure using forward
contingent contracts.
b, c
A bond dealer uses his own equity to buy Mexican debt on the less-developed country
(LDC) bond market.
a, b, e, f
A securities firm sells a package of mortgage loans as mortgage backed securities.
A, b, c

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
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.