Response to the following problem:
A financial institution has the following market value balance sheet structure:
|
Assets
|
Liabilities and Equity
|
|
|
Cash
|
$ 1,000
|
Certificate of deposit
|
$10,000
|
|
Bond
|
10,000
|
Equity
|
1,000
|
|
Total assets
|
$11,000
|
Total liabilities and equity
|
$11,000
|
a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year?
b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?
c. Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part ( a ) is used to cover operating expenses or is distributed as dividends.
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 $1,000? Why?
e. What factors have caused the changes in operating performance and market value for this firm?