Question

In: Finance

7. Consider a F/I with the following balance sheet: Assets consisting of Cash of $150M; Loans...

7. Consider a F/I with the following balance sheet: Assets consisting of Cash of $150M; Loans of $1,500M at 12% with a duration of 1.75 years; and, Treasuries of $350M at 9% with a 7.00 year duration. Liabilities consisting of time deposits of $700M at 7% with a 1.75 year duration; CDs of $1,150M at 8% with a duration of 2.50 years; and, equity of $150M. Calculate the duration gap and state the F/I's interest rate risk exposure.

+1.03 years; exposed to interest rate increases.

+0.32 years; exposed to interest rate increases.

+0.86 years; exposed to interest rate increases.

+0.49 years; exposed to interest rate increases.

-1.32 years; exposed to interest rate decreases.

Solutions

Expert Solution

Solution: CORRECT ANSWER is D) +0.49 years; exposed to interest rate increases.

Assets Market Value Yield Duration(Years)
Cash 150
Loans 1500 12.00% 1.75
Treasuries 350 9.00% 7
Total assets 2000
Liabilities Market Value Rate Duration Years
Time Deposits 700 7.00% 1.75
CDs 1150 8.00% 2.5
Total liabilities 1850
Equity 150
Total 2000
Weighted Average Duration of Bank assets (Da) = Summation of the product of weights of individual assets and their respective Duration years. Where, weight of individual asset = Market value of that asset divided by the market value of all bank assets (1500/2000)*1.75 + (350/2000)*7 = 2.5375
Weighted Average Duration of Bank Liabilities (Dl) = Summation of the product of weights of individual liabilities and their respective Duration years. Where, weight of individual liability = Market value of that liability divided by the market value of all bank liabilities (700/1850)*1.75 + (1150/1850)*2.5 = 2.216
Duration Gap = Weighted average duration of assets -(Market value of liabilities/Market value of assets)*(Weighted average duration of liabilities) = (2.5375) - ((1850/2000)*2.216) = 0.4875 +0.49

The duration gap is +0.49 and positive duration gap means that the market value of equity of F/I will fall when interest rates rise. So, F/I is exposed to interest rate increases.


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