Question

Consider the following balance sheet for WatchoverU Savings Inc. ($ in millions):

Assets				Liabilities
Floating-rate mortgages (currently 10% annually)	$	60		NOW accounts (currently 6% annually)	$	80
30-year fixed-rate loans (currently 7% annually)		60		Time deposits (currently 6% annually)		24
				Equity		16
Total	$	120			$	120

a. What is WatchoverU’s expected net interest income at year-end?
b. What will be the net interest income at year-end if interest rates rise by 2 percent?

Answer 1

Question a)

Liabilities -

Now Account - 4.80

Time Deposit - 1.44

Total - 6.24

Asset -

Floating Rate Mortgage - 6

Fixed Rate Loan - 4.20

Total - 10.20

Net Interest Income - (10.20 - 6.24) = 3.96

Question b)

Liabilities -

Now Account - 6.40 (Now Accounts are sensitive to the changing interest rates as these types of accounts are short term in nature and do not have a fixed rate.)

Time Deposit - 1.44 (Time deposits are for a defined period at a fixed rate in which the money is invested)

Total - 7.84

Assets -

Floating Rate Mortgage - 7.20 (interest increased from 10% to 12% as it is a floating rate mortgage. Floating rate instruments have their interest rates linked to the market (like FED Funds decided by FOMC) + some spread decided by the banks depending on the credit quality of the borrower. )

Fixed Rate Loan - 4.20 (Insensitive to the changing interest rates. During the time of lower rates, borrowers who have been paying fixed rates would be stuck as they would need to pay higher than the market rates which is a disadvantage of the fixed rate loan to the borrower).

Total - 11.40

Net Interest Income - (11.40 - 7.84) = 3.56

Increase in the interest rate has a predominant effect on the liabilities due to which the Net Interest Income has reduced by 400,000.