## QUESTION 1b Calculate the convexity for a three-year 5% coupon rate with a face value of \$500,000 loan. What is the convexity of the same loan but with amortized payments? Use this information to determine the impact on the market value of the bond loan and the amortized loan if the entire yield curve shifted downward 50-basis points. What is the usefulness of convexity when duration is available as a measure of interest rate risk? What is the practical implication for the three-year loan in this example?

QUESTION 1a

Use this balance sheet information to answer the following questions:

 Financial Institution (FI) Balance Sheet (Amount in millions, Duration in years) Assets Amount Duration Liabilities Amount Duration Cash 50 ? Core Deposits 750 1.25 yrs Treasury Bonds 350 1.95 yrs CDs 300 1.00 yrs Loans (special) 650 ? Euro CDs ? 0.75 yrs Loans (fixed) 450 3.25 yrs Equity 150

The bank has granted a special loan that has 3 years to maturity and has repayments of \$357.875 million at the end of year 1, no payment at the end of year 2, and \$357.875 payments at the end of year 3. The loan is trading at par and the yield to maturity is 5 percent per annum.

Assuming a flat yield curve and a parallel shift of the entire yield curve of 50-basis points upward what is the impact on the FI’s market value of equity?

QUESTION 1b

Calculate the convexity for a three-year 5% coupon rate with a face value of \$500,000 loan. What is the convexity of the same loan but with amortized payments?

Use this information to determine the impact on the market value of the bond loan and the amortized loan if the entire yield curve shifted downward 50-basis points.

What is the usefulness of convexity when duration is available as a measure of interest rate risk? What is the practical implication for the three-year loan in this example?

QUESTION 2a

Incorporate finance the leverage ratio can be calculated by dividing capital by book value of assets. How have regulators altered this ratio to determine the capital adequacy requirements for banks or authorized depository institutions? Compare Gorajek and Turner’s (2010)[1] analyses to those presented in Lange et al. (2015), Chapter 18. In your discussion consider the tension between the bank and the regulators

QUESTION 2b

For many years, Australian Express Company offered a charge card, called the Australian Express Card, which required its holders to pay off, in full, their card charges at the end of each monthly billing period.  In other words, cardholders could not maintain outstanding unpaid balances as VISA bank credit cardholders could.

Recently, however, Australian Express introduced a second card called the Optima Card, which was more like VISA credit cards in that Optima cardholders did not have to pay off all their unpaid balances. The interest rate charged by Australian Express was similar to other credit cards around 18%.

Assume that Australian Express Company cannot perfectly identify the credit risk of applicants for its two cards but takes equal care in checking card applicants for both cards.  Would you expect the default rate on the Optima Card to be lower, equal to, or higher than the Australian Express Card? Explain.

QUESTION 3a

Data sourced from Ifess (Integrated Fast time Equity System) has given the following swap rates. Think of these swap rates as spot interest rates.

 Swap maturity 30 June 2019 30 June 2020 1 year 3.250 3.00 2 year 3.150 3.28 3 year 2.750 3.12 4 year 3.150 3.07 5 year 3.550 3.25

(i)Using the data as given on 30 June 2019, calculate the relevant forward rates. State exactly what information each of these forward rates gives.

(ii) Now using the data from the table for 30 June 2020 state the 1-year, 2-year, 3-and 4-year year spot rates that prevailed on that date. What appears to have happened?

(iii)Using the data as given on 30 June 2020, calculate the relevant forward rates.

QUESTION 3b

A financial institution has the following balance:

 Balance Sheet (in million) Assets Liabilities Cash 18 Deposits 140 Government securities 18 Borrowed Funds 20 Other Assets 164 Equity 40 Total 200 Total 200

In 2020 COVID-19 increased the liquidity needs of a bank servicing the affected community as depositors withdrew deposits to the value of \$40 million.

 Withdrawal of Deposits Assets Liabilities Cash Deposits Government securities Borrowed Funds Other Assets Equity Total Total

Would you recommend this bank rely more on asset liquidity or liability liquidity to meet these additional requirements? Give reasons. Show how you would manage the bank’s liquidity position. What other information that the financial institution would possess would improve your decision. Be specific.

QUESTION 4a

Some members of the accounting profession are advocating market value accounting for banks.

Explain the arguments for and against market-value accounting. In your answer ensure that you clearly explain “real losses” and “paper losses” and the role of moral hazard in the application of market value accounting. Use a simplified bank balance sheet to illustrate your response.

QUESTION 4b

Using the data in the table below, determine the return on asset, sustainable growth rate, and projected capital ratio.

 Sustainable Internal Growth for Banks Average total assets \$1,000,000,000 Average equity capital \$68,000,000 Expected net profit margin (%) 8.75 Expected yield on average total assets (%) 14.00 Cash dividend payout percentage (%) 30.00 Planned asset growth rate (%) 12.00

Using an appropriate method shows which variable has the greatest impact on sustainable growth.