Question

QUESTION 55

1. Bank Asset Bond A				Bank Liability L
   Settlement	43643			Settlement	43643
   Maturity	50948			Maturity	47296
   Rate	10%			Rate	8%
   Yield	9%			Yield	7%
   Redemption	100			Redemption	100
   frequency	2			frequency	2
   basis	0			basis	0

   Assume that the only bank asset is the bond A above and the only bank liability is the liability L above.

   What happens to bank capital (also called net worth) if the market yields decline by 100 basis points.

   Bank capital declines TRUE OR FALSE (IS IT TRUE OR FALSE THAT BANK CAPITAL DECLINES IN THIS SITUATION)

Answer 1

The given statement is FALSE.

As a first step, let's calculate the net worth in the as - is situation.

We need to calculate the value of asset (i.e. Bond A) and the liability ( Bond L). I have used excel formula "PRICE" to calculate the same. Please see the table below:

Net Worth currently = Asset - Liabilities = 109.20 - 107.11 = 2.09

We repeat the same task when yield decreases by 100 bps = 1%. Please see the table below:

Net worth revised = 119.79 - 114.88 = 4.92 > Earlier net worth.

Hence, Bank capital increases. Hence the given statement is FALSE.