Question

In: Finance

You are working at a bank, and after analyzing the $295 million portfolio of debt securities,...

You are working at a bank, and after analyzing the $295 million portfolio of debt securities, you have determined a portfolio duration of 3.65, and an average Yield to Maturity of 5.65%. If you believe interest rates will be increasing by 0.75%, what is your expected change in portfolio value? If on the other hand, the prevailing wisdom is that rates will drop by 0.25%, what is the expect change in portfolio value? Briefly, what is wrong with this type of analysis? Additionally, what would be wrong with regulators coming in and asking you to repeat this analysis for an increase in interest rates of 3%?

Solutions

Expert Solution

Portfolio Value $          295,000,000
Portfolio Duration = 3.65
YTM = 5.65%
Modified Duration= Portfolio Duration /(1+YTM)
So Modified Duration=3.65/(1+0.0565)=3.45.
As we know for every % change in Interest rate
there will be Modified Duration*same % change in price in the opposite direction.
A
Interest rate change % Change in Porfoilio Price=-Modified Duration *% nterest change Amount of Porfolio Price change =$295M*A
Increase by 0.75% -2.59% $           (7,633,125)
Drop by 0.25% 0.86% $             2,544,375
The issue with such analysis is that in case od sharp increase or decrease
in interest rate, the process will overestimate or underestimate the
corresponding change in price.
Therefore the analysis can throw some projections which may give
wrong forecasts and may create confusions.
Market regulators may have objections in such cases as the projections
can be quite misleading. Generally the convexity parameter is
considered to avoid such issues.

Related Solutions

​You are working at a bank, and after analyzing the $295 million portfolio of debt securities,...
​You are working at a bank, and after analyzing the $295 million portfolio of debt securities, you have determined a portfolio duration of 3.65, and an average Yield to Maturity of 5.65%. If you believe interest rates will be increasing by 0.75%, what is your expected change in portfolio value? If on the other hand, the prevailing wisdom is that rates will drop by 0.25%, what is the expect change in portfolio value? VERY briefly, what is wrong with this...
Case study: the right portfolio After working as a securities broker for 20 years, Simon Eckstein...
Case study: the right portfolio After working as a securities broker for 20 years, Simon Eckstein decided to lead a less hectic life. He set up an investment consulting firm 2 years ago and has rapidly built his reputation as the best consultant on securities investment in the area. Today, 5 clients called on Simon for his advice on their investment plans. The first is a 35-year-old divorced woman who has 2 teenage sons and wants to invest $50,000. the...
You are analyzing the after-tax cost of debt for a firm. You know that the firm’s...
You are analyzing the after-tax cost of debt for a firm. You know that the firm’s 12-year maturity, 17.00 percent semiannual coupon bonds are selling at a price of $1,482.95. These bonds are the only debt outstanding for the firm. What is the current YTM of the bonds?= in %? (Round final answer to 2 decimal places, e.g. 15.25%.)
You are analyzing the after-tax cost of debt for a firm. You know that the firm’s...
You are analyzing the after-tax cost of debt for a firm. You know that the firm’s 12-year maturity, 9.00 percent semiannual coupon bonds are selling at a price of $898.98. These bonds are the only debt outstanding for the firm. What is the current YTM of the bonds? (Round final answer to 2 decimal places, e.g. 15.25%.) YTM % LINK TO TEXT What is the after-tax cost of debt for this firm if it has a marginal tax rate of...
You are working at Bank of America Merrill Lynch as a Portfolio Manager. You are thinking...
You are working at Bank of America Merrill Lynch as a Portfolio Manager. You are thinking about rebalancing clients portfolio position and researching on various industries, i.e., housing construction, health care, energy, technology, financials, coal mining, and steel production. Choose one or two industry that you would expect to perform best in future. Write a brief summary and explain why you client would be convinced by your decision.
You are analyzing Delta Enterprises, a small publicly traded company with $50 million of debt outstanding,...
You are analyzing Delta Enterprises, a small publicly traded company with $50 million of debt outstanding, and 25 million shares, trading at $10/share. The firm generated $40 million in after-tax cash flows last year, and you esti- mate that these cash flows will grow 2% a year in perpetuity and that the cost of capital for the firm is 12%. a. Estimate a value per share for the firm, assuming it has no cash balance. b. Now assume that you...
Addison Manufacturing holds a large portfolio of debt securities as an investment. The fair value of...
Addison Manufacturing holds a large portfolio of debt securities as an investment. The fair value of the portfolio is greater than its original cost, even though some debt securities have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this securities portfolio in accordance with GAAP. Beresford wants to classify those securities that have increased in value during the period as trading securities...
Addison Manufacturing holds a large portfolio of debt securities as an investment. The fair value of...
Addison Manufacturing holds a large portfolio of debt securities as an investment. The fair value of the portfolio is greater than its original cost, even though some debt securities have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this securities portfolio in accordance with GAAP. Beresford wants to classify those securities that have increased in value during the period as trading securities...
(a) Imperial Bank has deposits of $150 million and securities of $110m; the bank also makes...
(a) Imperial Bank has deposits of $150 million and securities of $110m; the bank also makes loans to its customers. Construct the balance sheet of the bank if the bank is regulated and required to retain 10% of its deposits as reserves (b) What is the numerical value of the bank capital of Imperial Bank? (c) Suppose the bank makes bad loans to the tune of $5m, show and explain how the balance sheet will be altered.
Blue Sunday Bank has a portfolio of loans and securities, as well as deposits and money...
Blue Sunday Bank has a portfolio of loans and securities, as well as deposits and money market borrowings, which are expected to produce the following cash inflows and outflows for the bank in the coming 5 years. Explain the danger of the bank’s position. What kind of hedging should the bank use to reduce its risk and what's the expected effect? Duration of Total Cash Inflows Expected Cash Flow Cash Flow Timeline Current Year Present Value (4.5%) Present Value Weight...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT