Question

A financial institution has the following balance sheet structure:

Assets	USD million	Liabilities	USD million
Cash	10	Equity	30
Bond	100	Certificate of Deposit	100
Real Estate	20
Total	130	Total	130

The USD 100 million bond has a three year maturity paying 10 percent interest per year. The USD 100 million certificate of deposit has a two-year maturity and paying 8 percent interest per year. The bond and certificate of deposit will be rolled over after their maturities at the respective prevailing market rates. The financial institution expects no additional asset growth.

1. a) What will be the financial institution’s net interest income (NII) over the five-year investment horizon if the interest rate decreases by 1 percent per annum after the first year and decreases by 1 percent per annum after the third year?

2. b) What will be the financial institution’s net interest income (NII) over five-year investment horizon if the interest rate increases by 1 percent per annum after the second year and increases by 1 percent per annum after the fourth year?

3. c) Assuming that market interest rates increase by 1 per cent, the bond will have a value of USD99.9 million at the end of year one. What will be the market value of the equity for the financial institution? Assume that all of the NII in part a) is used to cover operating expenses or is distributed as dividends.

   (2.5 Marks)

4. 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 USD30 million? Why?

Answer 1

Net Interest Income (NII) = Interest recieved on lending/Bond - Interest to be paid on Borrowings/CD's

Part-a)

Market interest rates

Year	Market interest rate on Bond %	Market interest rate on CD %
1	10	8
2	9 = (10-1)	7 = (8-1)
3	9	7
4	8 = (9-1)	6 = (7-1)
5	8	6

Matuarity for Bond- 3 years

Matuarity for CD - 2 years

NII:

Particulars	1	2	3	4	5
Interest rate on Bond	10%	10%	10%	8%	8%
Interest to be received on Bonds (100*interest rate) (A)	10	10	10	8	8
Interest rate on CD	8%	8%	7%	7%	6%
Interest to be paid on CD (B)	8	8	7	7	6
Net Interest Income (NII)	2	2	3	1	2

It is assumed that after matuarity of instuments, they will be roll over with same matuarity of 3 years and 2 years for Bonds and CDs, respectively.

Part - b):

Market interest rates

Year	Market interest rate on Bond %	Market interest rate on CD %
1	10	8
2	10	8
3	11 = 10+1	9 = 8+1
4	11	9
5	12 = 11+1	10 = 9+1

Matuarity for Bond- 3 years

Matuarity for CD - 2 years

NII:

Particulars	1	2	3	4	5
Interest rate on Bond	10%	10%	10%	11%	11%
Interest to be received on Bonds (100*interest rate) (A)	10	10	10	11	11
Interest rate on CD	8%	8%	9%	9%	10%
Interest to be paid on CD (B)	8	8	9	9	10
Net Interest Income (NII) (A-B)	2	2	1	2	1

It is assumed that after matuarity of instuments, they will be roll over with same matuarity of 3 years and 2 years for Bonds and CDs, respectively. Hence the rate has been locked despite change in market interest rates.

Part - c):

As the market interest rate increses market price of the bond decreases hence there is reduction in price of the bond.

Also bond has a fixed matuarity of 3 years and during that period comapny will receive the fixed coupon @ 10%. Same is the case with CD as it has matuarity of 2 years i.e. company will pay interest @ 8% for 2 years.

NII will remain same for 2 years and it is assumed that all of the NII has been utilised for operating expenses or declaring Dividend, hence no increase in reserves of the company.

But the value of Bond (Asset) has been decreased hence the loss on reduction in price of bond will be reflected in the share price of the company. Price will get reduced by (100-99.9) = 0.1, which will translate to market value of Equity of = 30 - 0.1 = 29.90.

Part - d):

Price of the shares will increase as the market interest rate decreses market price of the bond increases hence there will be a increase in the price of Bond. Asset size of the company will increase correspondingly price of the share will also increase.