Bruce Honiball's Invention
It was another disappointing year for Bruce Honiball, the manager of retail services at the Gibb River Bank. Sure, the retail side of Gibb River was making money, but it didn't grow at all in 2015. Gibb River had plenty of loyal depositors, but few new ones. Bruce had to figure out some new product or financial service-something that would generate some excitement and attention. Bruce had been musing on one idea for some time. How about making it easy and safe for Gibb River's customers to put money in the stock market? How about giving them the upside of investing in equities-at least some of the upside-but none of the downside? Bruce could see the advertisements now:
How would you like to invest in Australian stocks completely risk-free? You can with the new Gibb River Bank Equity-Linked Deposit. You share in the good years; we take care of the bad ones. Here's how it works. Deposit A$100 with us for one year. At the end of that period you get back your A$100 plus A$5 for every 10% rise in the value of the Australian All Ordinaries stock index.
But, if the market index falls during this period, the Bank will still refund your A$100 deposit in full. There's no risk of loss. Gibb River Bank is your safety net. Bruce had floated the idea before and encountered immediate skepticism, even derision: "Heads they win, tails we lose-is that what you're proposing, Mr. Honiball?" Bruce had no ready answer. Could the bank really afford to make such an attractive offer? How should it invest the money that would come in from customers?
The bank had no appetite for major new risks. Bruce has puzzled over these questions for the past two weeks but has been unable to come up with a satisfactory answer. He believes that the Australian equity market is currently fully valued, but he realizes that some of his colleagues are more bullish than he is about equity prices. Fortunately, the bank had just recruited a smart new MBA graduate, Sheila Liu. Sheila was sure that she could find the answers to Bruce Honiball's questions.
First she collected data on the Australian market to get a preliminary idea of whether equity-linked deposits could work. These data are shown in Table . She was just about to undertake some quick calculations when she received the following further memo from Bruce: Sheila, I've got another idea. A lot of our customers probably share my view that the market is overvalued. Why don't we also give them a chance to make some money by offering a "bearmarket deposit"?
If the market goes up, they would just get back their A$100 deposit. If it goes down, they get their A$100 back plus $5 for each 10% that the market falls. Can you figure out whether we could do something like this? Bruce.
| Year |
Interest Rate |
Market Return |
Dividend Yield |
Year |
Interest Rate |
Market Return |
Dividend Yield |
| 1995 |
8.00% |
20.20% |
4 |
2005 |
5.60% |
21.10% |
3.8 |
| 1996 |
7.4 |
14.6 |
4.1 |
2006 |
5.9 |
25 |
3.8 |
| 1997 |
5.5 |
12.2 |
3.7 |
2007 |
6.6 |
18 |
4.3 |
| 1998 |
5 |
11.6 |
3.6 |
2008 |
7.3 |
-40.4 |
6.8 |
| 1999 |
4.9 |
19.3 |
3.3 |
2009 |
3.2 |
39.6 |
5.3 |
| 2000 |
5.9 |
5 |
3.3 |
2010 |
4.3 |
3.3 |
4.2 |
| 2001 |
5.2 |
10.1 |
3.3 |
2011 |
4.8 |
-11.4 |
4.4 |
| 2002 |
4.6 |
-8.1 |
3.5 |
2012 |
3.7 |
18.8 |
5.1 |
| 2003 |
4.8 |
15.9 |
4.2 |
2013 |
2.8 |
19.7 |
4.5 |
| 2004 |
5.4 |
27.6 |
3.7 |
2014 |
0.6 |
5 |
4.5 |
Questions:
What kinds of options is Bruce proposing? How much would the options be worth? Would the equity-linked and bear-market deposits generate positive NPV for Gibb River Bank?