Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet

SOLUTIONS MANUAL
Chapter Twenty-Two
Answers to Chapter 22
Questions:
1. The repricing gap is a measure o the dierence !et"een the dollar value o assets that "ill
reprice and the dollar value o lia!ilities that "ill reprice "ithin a speciic time period# "here
repricing can !e the result o a roll over o an asset or lia!ility $e.g.# a loan is paid o at or prior
to maturity and the unds are used to issue a ne" loan at current market rates% or !ecause the
asset or lia!ility is a varia!le rate instrument $e.g.# a varia!le rate mortgage "hose interest rate is
reset every &uarter !ased on movements in a prime rate%. Rate sensitivity represents the time
interval "here repricing can occur. The model ocuses on the potential changes in the net interest
income varia!le. In eect# i interest rates change# interest income and interest e'pense "ill
change as the various assets and lia!ilities are repriced# that is# receive ne" interest rates.
2. The maturity !ucket is the time "indo" over "hich the dollar amounts o assets and lia!ilities
are measured. The length o the repricing period determines "hich o the securities in a portolio
are rate-sensitive. The longer the repricing period# the more securities either mature or "ill !e
repriced# and# thereore# the more the interest rate risk e'posure. (n e'cessively short repricing
period omits consideration o the interest rate risk e'posure o assets and lia!ilities are that
repriced in the period immediately ollo"ing the end o the repricing period. That is# it
understates the rate sensitivity o the !alance sheet. (n e'cessively long repricing period
includes many securities that are repriced at dierent times "ithin the repricing period# there!y
overstating the rate sensitivity o the !alance sheet.
). The C*(+ eect descri!es the relations !et"een changes in interest rates and changes in net
interest income. (ccording to the C*(+ eect# "hen C*(+ is positive the change in ,II is
positively related to the change in interest rates. Thus# an -I "ould "ant its C*(+ to !e positive
"hen interest rates are e'pected to rise. (ccording to the C*(+ eect# "hen C*(+ is negative
the change in ,II is negatively related to the change in interest rates. Thus# an -I "ould "ant its
C*(+ to !e negative "hen interest rates are e'pected to all.
.. (ccording to the C*(+ eect# "hen C*(+ is positive the change in ,II is positively related
to the change in interest rates. Thus# an -I "ould "ant its C*(+ to !e positive "hen interest
rates are e'pected to rise.
a. /es. This change "ill increase RS(s# "hich "ill increase *(+.
!. ,o. This change "ill decrease RS(s# "hich "ill decrease *(+.
c. ,o. This change "ill increase RS0s# "hich "ill decrease *(+.
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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
d. ,o. This change "ill have no impact on either RS(s or RS0s. So# the change "ill have no
impact on *(+.
e. /es. This change "ill increase RS(s# "hich "ill increase *(+.
1. 2hen rates rise# the !ank manager "ould "ant to set the repricing gap greater than 3ero. (s
rates rise# interest income "ill increase !y more than interest e'pense# resulting in an increase in
net interest income. I rates are a!out to all the manger "ould like to set the repricing gap less
than 3ero. (s rates all# interest income "ill decrease !y less than interest e'pense# resulting in an
increase in net interest income.
4. The ollo"ing are rate sensitive5 a# b# d# f# g# h# i# and j.
6. a. The repricing model has our general "eaknesses5
i. It ignores market value eects.
ii. It does not take into account the act that the dollar value o rate sensitive assets and lia!ilities
"ithin a !ucket are not similar. Thus# i assets# on average# are repriced earlier in the !ucket than
lia!ilities# and i interest rates all# -Is are su!7ect to reinvestment risks.
iii. It ignores the pro!lem o runos# i.e.# that assets are prepaid and lia!ilities are "ithdra"n
!eore the maturity date.
iv. It ignores income generated rom o-!alance-sheet activities.
!. 0arge !anks are a!le to reprice securities every day using their o"n internal models so
reinvestment and repricing risks can !e estimated or each day o the year.
8. Taking the irst derivative o a !ond9s $or any i'ed-income security% price $+% "ith respect to
the yield to maturity $R% provides the ollo"ing5
D
R
dR
P
dP
=
+ % 1 $
The economic interpretation is that : is a measure o the percentage change in the price o a
!ond or a given percentage change in yield to maturity $interest elasticity%. This e&uation can !e
re"ritten to provide a practical application5
P
R
dR
D dP

+
=
1
In other "ords# i duration is kno"n# then the change in the price o a !ond due to small changes
in interest rates# R# can !e estimated using the a!ove ormula.
;. The change in the net "orth o an -I or a changes in interest rates is given !y the ollo"ing
e&uation5
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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
"here k < 0=(. Thus# three actors are important in determining >?5
i. @:( - :0 kA or the leveraged ad7usted duration gap. The larger this gap# the more e'posed is
the -I to changes in interest rates.
ii. (# or the si3e o the -I. The larger is (# the larger the e'posure to interest rate changes.
iii. >R=1 B R# or interest rate shocks. The larger the shock# the larger the e'posure to interest rate
changes.
1C. In this case the actual return earned "ould e'ceed the original yield. The !eneits rom a
higher reinvestment rate "ould e'ceed the price reduction eect i the investor gets to hold the
security long enough.
11. 2hen rates rise# the !ank manager "ould "ant to set the duration gap less than 3ero. (s rates
rise# the value o the lia!ilities "ill decrease !y more than the value o assets# resulting in an
increase in the market value o e&uity. I rates are a!out to all the manger "ould like to set the
duration gap greater than 3ero. (s rates all# the value o the assets "ill increase !y more than the
value o lia!ilities# resulting in an increase in the market value o e&uity.
12. The three criticisms are5
i. :uration matching can !e costly !ecause it is not easy to restructure the !alance sheet
periodically# especially or large -Is.
ii. Immuni3ation is a dynamic pro!lem !ecause duration changes over time. Thus# it is necessary
to re!alance your portolio as your assets and lia!ilities change over time.
iii. :uration is not an appropriate tool or immuni3ing portolios "hen the e'pected interest rate
changes are large !ecause o the e'istence o conve'ity. Conve'ity e'ists !ecause the
relationship !et"een !ond price changes and interest rate changes is not linear# "hich is assumed
in the estimation o duration. Dsing conve'ity to immuni3e a portolio "ill reduce the pro!lem.
1). Book value accounting reports assets and lia!ilities at the original issue values. Market value
accounting is an economist9s deinition o capital. Speciically# the economist=s deinition o an
-I=s capital# or o"ners9 e&uity stake# is the dierence !et"een the market values o its assets
and its lia!ilities. This is also called an -I9s market value. This is the economic meaning o
capital. ( pro!lem "ith !ook value accounting is that current market values may !e dierent
rom !ook values !ecause o changes in market conditions# such as interest rates or prices. This
is especially a pro!lem i an asset or lia!ility has to !e li&uidated immediately. I the asset or
lia!ility is held until maturity# then the reporting o !ook values does not pose a pro!lem.
-or an -I# the ma7or actor aecting asset and lia!ility values are interest rate changes. I
interest rates increase# the value o !oth loans $assets% and deposits and de!t $lia!ilities% all. I
assets and lia!ilities are held until maturity# it does not aect the valuation o the -I. Eo"ever# i
deposits or loans have to !e reinanced# then market value accounting presents a !etter picture o
the condition o the -I.
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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
1.. The !ook value deinition o capital is the value o assets minus lia!ilities as ound on the
!alance sheet. This amount oten is reerred to as accounting net "orth. The economic deinition
o capital is the dierence !et"een the market value o assets and the market value o lia!ilities.
a. The loss in value caused !y credit risk is !orne irst !y the e&uity holders# and then !y the
lia!ility holders. 2ith market value accounting# the ad7ustments to e&uity value are made
simultaneously as the losses due to this risk element occur. Thus# economic insolvency may !e
revealed !eore accounting value insolvency occurs.
!. Because !ook value accounting recogni3es the value o assets and lia!ilities at the time they
"ere placed on the !ooks or incurred !y the irm# losses are not recogni3ed until the assets are
sold or regulatory re&uirements orce the irm to make !alance sheet accounting ad7ustments. In
the case o credit risk# these ad7ustments usually occur ater all attempts to collect or restructure
the loans have occurred.
11. Market values produce a more accurate picture o the !ank9s current inancial position or
!oth stockholders and regulators. Stockholders could more readily see the eects o changes in
interest rates on the !ank9s e&uity. (s noted in the ne't pro!lem it also accurately relects the
li&uidation value o a distressed !ank. (mong the arguments against market value accounting are
that market values are sometimes diicult to estimate# particularly or small !anks "ith non-
traded assets. In addition# some argue that market value accounting "ould produce higher
volatility in the earnings o !anks.
14. The market value o e&uity is more relevant than !ook value !ecause in the event o a
!ankruptcy# the li&uidation $market% values "ill determine the -IFs a!ility to pay the various
claimants.
Probles:
1. a. Repricing gap < RS( - RS0 < G1CC - G1C million < BG1C million.
> ,II < $G1C million%$.C1% < BG.1 million# or G1CC#CCC.
!. Repricing gap < RS( - RS0 < G1C - G11C million < - G1CC million.
> ,II < $-G1CC million%$.C1% < -G1 million# or -G1#CCC#CCC.
c. Repricing gap < RS( - RS0 < G61 - G6C million < BG1 million.
G> ,II < $G1 million%$.C1% < G.C1 million# or G1C#CCC.
d. The -Is in parts $a% and $c% are e'posed to interest rate declines $positive repricing gap%#
"hile the -I in part $!% is e'posed to interest rate increases. The -I in part $c% has the least
amount o interest rate risk e'posure since the a!solute value o the repricing gap is the lo"est#
"hile the opposite is true or part $!%.
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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
2. a. ?'pected interest income5 $G4Cm ' .1% B $G;Cm ' .C6% < G12.)m
?'pected interest e'pense5 $G1C1m ' .C4% B $G21m ' .C4% < G6.8m
?'pected net interest income5 G12.)m - G6.8m < G..1m

!. (ter the 2CC !asis point interest rate increase# net interest income declines to 4Cm$.12% B
;Cm$.C6% - $1C1m$.C8% B 21m$.C4%% < G1).1m - G;.;m < G).4m# a decline o GC.; m.
c. 2atchoverD9s repricing or unding gap is G4Cm - G1C1m < -G.1m. The change in net
interest income is $-G.1m%$.C2% < -GC.;m.
). a. Current e'pected interest income5 G1Cm$C.1C% B G1Cm$C.C6% < G8.1m. ?'pected interest e'pense5
G6Cm$C.C4% B G2Cm$C.C6% < G1.4m. ?'pected net interest income5 G8.1m - G1.4m < G2.;m.
!. (ter the 2CC !asis point interest rate increase# net interest income declines to5
1C$C.12% B 1C$C.C6% - 6C$C.C8% - 2C$.C6% < G;.1m - G6.Cm < G2.1m# a decline o GC..m.
c. 2atchovia9sF repricing or unding gap is G1Cm - G6Cm < -G2Cm. The change in net interest
income using the unding gap model is $-G2Cm%$C.C2% < -G..m.
d. (ter the une&ual rate increases# net interest income "ill !e 1C$C.12% B 1C$C.C6% - 6C$C.C6%
- 2C$.C6% < G;.1m - G4.)m < G).2m# an increase o GC.)m. It is not uncommon or interest rates to
ad7ust in an une&ual manner on RS(s versus RS0s. Interest rates oten do not ad7ust solely
!ecause o market pressures. In many cases the changes are aected !y decisions o
management. Thus# you can see the dierence !et"een this ans"er and the ans"er or part a.
.. a. Repricing *(+ < G11C#CCC - G)61#CCC < G161#CCC
*ap ratio < G161#CCC=G1#16C#CCC < 11.11H
!. II < G11C#CCC$.CC.1% < G2#.61
I? < G)61#CCC$.CC)1% < G1#)12.1C
,II < G2#.61 - G1#)12.1C < G1#142.1C
c. The C*(+ aect "orked to increase net interest income. That is# the C*(+ "as positive
"hile interest rates increased. Thus# interest income increased !y more than interest e'pense. The
result is an increase in ,II. The spread eect also "orked to increase net interest income. The
spread increased !y 1C !asis points. (ccording to the spread aect# as spread increases# so does
net interest income.
1. a. -unding or repricing gap using a )C-day planning period < G61m - G16Cm < -G;1 million.
-unding gap using a ;1-day planning period < $G61m B G61m% - G16Cm < G2C million.
-unding gap using a t"o-year planning period < $G61m B G61m B G1Cm B G21m% - G16Cm < B
G11 million.
!. ,et interest income "ill decline !y G.61#CCC. That is# > ,II < *(+$> R% < -;1m$.CC1% <
G.61#CCC
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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
c. -unding or repricing gap over the 1-year planning period < $G61m B G61m B G1Cm B G2Cm
B G21m% -G16Cm < BG)1 million.
d. ,et interest income "ill increase !y G261#CCC. That is# >,II < *(+$> R% < )1m$.CC1% <
G161#CCC.
4. a. Time cash lo"s +IC- +IC- ' t
1 1CC 86.62 86.62
2 1#1CC 8.4..1 1#4;2.82
;)..1) 1#68C.1.
:uration < 1#68C.1.=;)..1) < 1.;C4 years
!. >+=+ < -:$>R=$1 B R%% or >+ < + ' $-:%$>R=$1 B R%%
< G;)..1) ' $-1.;C4% ' $-C.CC1C%=$1 B .1.% < G6.81 increase in the price o the !ond.
6. a. :uration o the t"o-year lia!ility < 1.8;6 years.
Time cash lo" +IC- +IC- ' t
C.1 )2#421 )1#.8. 11#6.2
1.C )2#421 )C#)82 )C#)82
1.1 )2#421 2;#)2C .)#;6;
2.C ;)2#421 8C8#81. 1#416#42;
;CC#CCC 1#6C6#6)2
:uration<1#6C6#6)2=;CC#CCC < 1.8;61

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0everaged ad7usted duration gap < @;.;. - $;CC#CCC=1#CCC#CCC%$1.8;61%A < 8.2) years
!. Change in net "orth using leveraged ad7usted duration gap is given !y5
< -@;.;. - $.;m=1m%$1.8;61%A$1m%$-C.CC2% < G14#.4..1
8. a. :uration o *BI9s i'ed-rate loan portolio5
Time cash lo" +IC- +IC- ' t
1 41'.12 4.;4.4 4.;4
2 41'.12 4.2181 12...
) 41'.12 1.111; 14.44
. 41'.12 ..;16C 1;.8)
1 $41'.12% B 41 .1.)C86 2C4.1.
41.CCCC 242..)
:uration < 242..)=41 < ..C)6 years.
!. :( < )C=22C $C% B $2C B 1C1%=22C $.)4% B 41=22C $..C)6% < 1.);6 years
c. :uration o *BIFs core deposits5
Time cash lo" +IC- +IC- ' t
1 2C ' .C8 1..811 1..8
2 $2C'.C8% B 2C 18.1181 )6.C.
2C.CCCC )8.12
:uration < )8.12=2C < 1.;24 years.
d. :0 < 2C=2CC ' $1.;24% B $1C B 1)C%=2CC ' $..C1% < .11)1 years
e. *BI=s leveraged ad7usted duration gap is5
1.);6 - 2CC=22C ' $.11)1% < .8;)8 years
Since *BIFs duration gap is positive# an increase in interest rates "ill lead to a decline in net
"orth. -or a 1H increase# the change in net "orth is5
>? < -C.8;)8 ' G22Cm ' $C.C1% < -G1#;44#)4C $ne" net "orth "ill !e G18#C))#4.C%.
;. a. The market value o the loan declines !y G2.11 million# to G;6..1 million.
MI( < G1Cm=$1B.111%
1
B G11Cm=$1B.111%
2
< $1Cm ' .8;4;% B $11Cm ' .8C..% < G;6..1 million.
!. The duration o the loan is 1.;C; years.
Time cach lo" +IC- +IC- J t
1 1C ;.C;C; ;.C;
2 11C ;C.;C;1 181.82
1CC.CCCC 1;C.;1
: < 1;C.;1=1CC < 1.;C; years.
c. The appro'imate change in the market value o the loan or a 11C !asis points change is5
MI( < -1.;C; ' G1CCm ' $C.C11=1.1% < -2.4C million
The e'pected market value o the loan using the a!ove ormula is G;6..C million.
d. The market value o the lia!ility declines G1.2)) million# to G88.646 million.
MI0 < $G;Cm B G6.2m% $1B.C;1%
1
< G;6.2m ' .;1)2 < G88.646 million
e. The duration is one year !ecause it is a pure discount $3ero-coupon% instrument.
1C. a. The "eighted average duration o the assets is5
$.1%$;C=)#C.1% B $.;%$11=)#C.1% B $..);)%$164=)#C.1% B $6%$2#62.=)#C.1% < 4.11 years
!. The "eighted average duration o the -IFs lia!ilities is5
$1%$2#C;2=2#))C% B $C.C1%$2)8=2#))C% < C.;C years
c. The -IFs leveraged ad7usted duration gap is5
:*(+ < :( - k:0 < 4.11 - $2#))C=)#C.1%$C.;C% < 1.84 years
The duration gap is positive# indicating that an increase in interest rates "ill lead to a decline in
net "orth.
d. The market value o the e&uity "ill change !y the ollo"ing or an appro'imate 1C !asis
point change in interest rates $i.e. >R=$1 B R% < C.CC1C% or !oth assets and lia!ilities5
>MI? < -:*(+ ' $(% ' >R=$1 B R% < -1.84$)#C.1%$C.CC1C% < -G8;.22 thousand.
The loss in e&uity o G8;#22C "ill reduce the e&uity $net "orth% to G421#68C.
e. I instead# >R=$1 B R% is -C.CC21# the change in the value o e&uity is5
>MI? < -1.84$)#C.1%$-C.CC21% < G..#41C
The market value o e&uity $net "orth% "ill increase !y G..#41C# to G61;#41C.