Assignment
1. Suppose that you work at the "Highly Pragmatic Bank". You are the head of the Risk Management Division. Your job is to decide how much money to spend on efforts to check whether clients who have borrowed money from the bank are living up to all the commitments they made to the bank. In other words, you have to decide how much to spend on monitoring borrowers.
Suppose that you are considering a new software and information system that would cost you $10,000. In addition, you would have to hire two people to operate the system. Each of these staff member's total compensation would be $30,000.
You are overseeing a portfolio of $10 million worth of loans. The loans bear a 3% rate of interest. You believe that the new system will raise the percentage of your customers who pay the interest on their loans from 80% to 95%.
a) Will the new system make money for "Highly Pragmatic Bank" in the first year?
b) Suppose that in the second year, $1000 is required to maintain and update the software. As the system becomes more familiar, only one staff member is needed to operate the software in year 2. 95% of your customers pay the interest again. Is the system now making money for "Highly Pragmatic Bank"? (Assume that only 80% of customers would have paid without the software.)
c. If subsequent years resemble year 2, is it worthwhile to buy the software? What other factors might influence your decision?
2. Suppose that you are real estate investor based in the US. You have large holdings of commercial real estate in Mexico City. The possibility of a US-Mexico trade war and its effects on the exchange rate of the dollar against the Mexican peso is giving you a great big headache. You are not sure what to do with your investments.
Here is how it looks. You own buildings worth 100 million Mexican Pesos in Mexico City. Your expenses and most of business are in US dollars, so you look at everything in terms of dollars. You are trying to figure out whether to sell the buildings or keep them. Here are some of the things you need to think about.
a. When the value of the peso dropped from about 18.12 Pesos/dollar to 21.33 Pesos/dollar after the US Presidential election last November, by how much did the value of your buildings (calculated in US dollars and in %) decrease?
b. Since Mexican real estate became cheaper for foreign investors, there might be increased demand after the election. You think that the prices of the buildings might well go up a little bit (calculated in pesos). But you are worried that a trade war will happen and the peso itself may get even weaker. Your guess is that there is about a 50-50 chance of a trade war.
Using the expected value approach explained below, calculate what your expected rate of return on the buildings in the next year would be based on the following information:
--There is a 10% chance the buildings will rise 3% in value (calculated in pesos) and the peso will fall 10%. (Mild trade war)
--There is a 40% chance the buildings will rise 5% in value (calculated in pesos) and the peso will fall 20% (Big trade war)
--There is a 50% chance the buildings will fall 2% in value (calculated in pesos) and the peso will rise 3%. (No trade war, love breaks out)
c. If you could either keep the buildings, or sell them and invest the dollars in the bank at 2% interest, which would be a better choice based on the information in part (b). Explain why.
3. The following is the balance sheet of 6th Eagle Scholarly Bank, a lending institution focusing on education and students
ASSETS LIABILITIES AND CAPITAL
25 Cash at bank premises 175 checking account deposits
50 Reserve Account at Fed 200 One-year time deposits
425 Loans to students for textbook purchase 625 money market deposits
350 Georgetown University bonds 425 Loan from 3rd Eagle Bank
700 Loans to other Colleges ??? Capital
a) Calculate the capital of 6th Eagle Scholarly Bank
b) If the Federal Government cuts back student loan programs, causing 30% of students to be unable to pay their textbook loans, what happens to the capital of 6th Eagle Bank? Is the bank solvent?
c) If regulators require the bank to have capital equal to at least 8% of the loans it gives out and the securities it owns, how much more capital would the bank need to meet this requirement after the events mentioned in part b)? (Use the new value of the student loans.) What could the bank do to satisfy this requirement?
d) Suppose that the Federal Reserve required that all banks hold reserves equal to 10% of checking deposits plus 1% of time deposits plus 2% of money market deposits. How much of 6th Eagle Scholarly Bank's reserves would be required reserves, and how much would be excess reserves?
4. Consider the balance sheet of Wildly Unethical Bank (WUB):
ASSETS LIABILITIES AND CAPITAL
20 Reserve account at the Fed, no interest 30 checking deposits, 0.1% annual interest
125 Auto loans, interest rate 150 money market deposits, interest changes
Changes quarterly yearly
200 Credit card loans, 830 Three-month time deposits, interest rate
Interest rate based on LIBOR, fixed during the three months
Adjusted every month
1200 Home mortgage loans, rates 360 Loans from other banks,
Adjusted semi-annually based on 10-year rates based on Prime Rate, changes weekly
Treasury bond 250 Capital
75 Bank premises
a) What is the gap between WUB's rate-sensitive assets and liabilities at 4 months maturity?
b) What is the gap between WUB's rate-sensitive assets and liabilities at 2 years maturity?
c) How much would WUB's net income change if all interest rates rose 2 percentage points 4 months from now?
EXPECTED VALUE DEFINITION: The expected value of a variable is the prediction we make given our knowledge of how likely it is that various outcomes happen, and our knowledge of the outcomes.
Example: a game where you get $2 each time a coin toss turns up heads, and $0 each time a coin toss turns up tails. We know that each outcome is equally likely-the probability of heads is 50%, and the probability of tails is 50%.
So the expected value of your winnings in this game is $2 x 0.5 + $0 x 0.5= $1. Note that we express the probability as a number between 0 and 1, using 0.5 to represent 50%, for example.
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.