Solutions for End-of-Chapter Questions and Problems: Chapter Eight

1. How do monetary policy actions made by the Federal Reserve impact interest rates?

Through its daily open market operations, such as buying and selling Treasury bonds and
Treasury bills, the Fed seeks to influence the money supply, inflation, and the level of interest
rates. When the Fed finds it necessary to slow down the economy, it tightens monetary policy by
raising interest rates. The normal result is a decrease in business and household spending
(especially that financed by credit or borrowing). Conversely, if business and household
spending decline to the extent that the Fed finds it necessary to stimulate the economy it allows
interest rates to fall (an expansionary monetary policy). The drop in rates promotes borrowing
and spending.

2. How has the increased level of financial market integration affected interest rates?

Increased financial market integration, or globalization, increases the speed with which interest
rate changes and volatility are transmitted among countries. The result of this quickening of
global economic adjustment is to increase the difficulty and uncertainty faced by the Federal
Reserve as it attempts to manage economic activity within the U.S. Further, because FIs have
become increasingly more global in their activities, any change in interest rate levels or volatility
caused by Federal Reserve actions more quickly creates additional interest rate risk issues for
these companies.

3. What is the repricing gap? In using this model to evaluate interest rate risk, what is meant
by rate sensitivity? On what financial performance variable does the repricing model
focus? Explain.

The repricing gap is a measure of the difference between the dollar value of assets that will
reprice and the dollar value of liabilities that will reprice within a specific time period, where
repricing can be the result of a roll over of an asset or liability (e.g., a loan is paid off at or prior
to maturity and the funds are used to issue a new loan at current market rates) or because the
asset or liability is a variable rate instrument (e.g., a variable rate mortgage whose interest rate is
reset every quarter based on movements in a prime rate). Rate sensitivity represents the time
interval where repricing can occur. The model focuses on the potential changes in the net interest
income variable. In effect, if interest rates change, interest income and interest expense will
change as the various assets and liabilities are repriced, that is, receive new interest rates.

4. What is a maturity bucket in the repricing model? Why is the length of time selected for
repricing assets and liabilities important when using the repricing model?

The maturity bucket is the time window over which the dollar amounts of assets and liabilities
are measured. The length of the repricing period determines which of the securities in a portfolio
are rate-sensitive. The longer the repricing period, the more securities either mature or will be
repriced, and, therefore, the more the interest rate risk exposure. An excessively short repricing
period omits consideration of the interest rate risk exposure of assets and liabilities are that
repriced in the period immediately following the end of the repricing period. That is, it
understates the rate sensitivity of the balance sheet. An excessively long repricing period
includes many securities that are repriced at different times within the repricing period, thereby
overstating the rate sensitivity of the balance sheet.

5. What is the CGAP effect? According to the CGAP effect, what is the relation between
changes in interest rates and changes in net interest income when CGAP is positive? When
CGAP is negative?

The CGAP effect describes the relation between changes in interest rates and changes in net
interest income. According to the CGAP effect, when CGAP is positive the change in NII is
positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive
when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative
the change in NII is negatively related to the change in interest rates. Thus, an FI would want its
CGAP to be negative when interest rates are expected to fall.

6. Which of the following is an appropriate change to make on a bank’s balance sheet

when GAP is negative, spread is expected to remain unchanged, and interest rates are
expected to rise?

According to the CGAP effect, when GAP, or CGAP, is positive the change in NII is positively
related to the change in interest rates. Thus, an FI would want its GAP to be positive when
interest rates are expected to rise.

a. Replace fixed-rate loans with rate-sensitive loans.

Yes. This change will increase RSAs, which will increase GAP.

b. Replace marketable securities with fixed-rate loans.

No. This change will decrease RSAs, which will decrease GAP.

c. Replace fixed-rate CDs with rate-sensitive CDs.

No. This change will increase RSLs, which will decrease GAP.

d. Replace equity with demand deposits.

No. This change will have no impact on either RSAs or RSLs. So, will have no impact on GAP.

e. Replace vault cash with marketable securities.

Yes. This change will increase RSAs, which will increase GAP.

7. If a bank manager was quite certain that interest rates were going to rise within the next six
months, how should the bank manager adjust the bank’s six-month repricing gap to take
 advantage of this anticipated rise? What if the manger believed rates would fall in the next
six months.

When interest rates are expected to rise, a bank should set its repricing gap to a positive position.
In this case, as rates rise, interest income will rise by more than interest expense. The result is an
increase in net interest income. When interest rates are expected to fall, a bank should set its
repricing gap to a negative position. In this case, as rates fall, interest income will fall by less
than interest expense. The result is an increase in net interest income.

8. Consider the following balance sheet positions for a financial institution:

 Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million

 Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million

 Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million

a. Calculate the repricing gap and the impact on net interest income of a 1 percent
increase in interest rates for each position.

 Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.

Repricing gap = RSA - RSL = $200 - $100 million = +$100 million.

NII = ($100 million)(0.01) = +$1.0 million, or $1,000,000.

 Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million.

Repricing gap = RSA - RSL = $100 - $150 million = -$50 million.

NII = (-$50 million)(0.01) = -$0.5 million, or -$500,000.

 Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million.

Repricing gap = RSA - RSL = $150 - $140 million = +$10 million.

NII = ($10 million)(0.01) = +$0.1 million, or $100,000.

b. Calculate the impact on net interest income on each of the above situations assuming a
1 percent decrease in interest rates.

 NII = ($100 million)(-0.01) = -$1.0 million, or -$1,000,000.

 NII = (-$50 million)(-0.01) = +$0.5 million, or $500,000.

 NII = ($10 million)(-0.01) = -$0.1 million, or -$100,000.

c. What conclusion can you draw about the repricing model from these results?
The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap), while
the FI in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest
rate risk exposure since the absolute value of the repricing gap is the lowest, while the opposite is
true for the FI in part (1).

9. Consider the following balance sheet for MMC Bancorp (in millions of dollars):

Assets Liabilities/Equity
1. Cash and due from $ 6.25 1. Equity capital (fixed) $25.00
2. Short-term consumer loans 62.50
(one-year maturity) 2. Demand deposits 50.00
3. Long-term consumer loans 31.25
(two-year maturity) 3. One-month CDs 37.50
4. Three-month T-bills 37.50 4. Three-month CDs 50.00
5. Six-month T-notes 43.75 5. Three-month bankers’
acceptances 25.00
6. Three-year T-bonds 75.00 6. Six-month commercial paper 75.00
7. 10-year, fixed-rate mortgages 25.00 7. One-year time deposits 25.00
8. 30-year, floating-rate
mortgages 50.00 8. Two-year time deposits 50.00
9. Premises 6.25
$337.50 $337.50

a. Calculate the value of MMC’s rate-sensitive assets, rate sensitive liabilities, and
repricing gap over the next year.

Looking down the asset side of the balance sheet, we see the following one-year rate-sensitive
assets (RSA):

1. Short-term consumer loans: $62.50 million, which are repriced at the end of the year and just
make the one-year cutoff.
2. Three-month T-bills: $37.50 million, which are repriced on maturity (rollover) every three
months.
3. Six-month T-notes: $43.75 million, which are repriced on maturity (rollover) every six
months.
4. 30-year floating-rate mortgages: $50.00 million, which are repriced (i.e., the mortgage rate is
reset) every nine months. Thus, these long-term assets are RSA in the context of the repricing
model with a one-year repricing horizon.

Summing these four items produces one-year RSA of $193.75 million. The remaining $143.75
million is not rate sensitive over the one-year repricing horizon. A change in the level of interest
rates will not affect the interest revenue generated by these assets over the next year. The $6.25
million in the cash and due from category and the $6.25 million in premises are nonearning
assets. Although the $131.25 million in long-term consumer loans, three-year Treasury bonds,
and 10-year, fixed-rate mortgages generate interest revenue, the level of revenue generated will
not change over the next year since the interest rates on these assets are not expected to change
(i.e., they are fixed over the next year).

Looking down the liability side of the balance sheet, we see that the following liability items
clearly fit the one-year rate or repricing sensitivity test:

1. One-month CDs: $37.50 million, which mature in one months and are repriced on rollover.
2. Three-month CDs: $50 million, which mature in three months and are repriced on rollover.
3. Three-month bankers’ acceptances: $25 million, which mature in three months and are
repriced on rollover.
4. Six-month commercial paper: $75 million, which mature and are repriced every six months.
5. One-year time deposits: $25 million, which are repriced at the end of the one-year gap
horizon.

Summing these five items produces one-year rate-sensitive liabilities (RSL) of $212.5 million.
The remaining $125 million is not rate sensitive over the one-year period. The $25 million in
equity capital and $50 million in demand deposits do not pay interest and are therefore classified
as nonpaying. The $50 million in two-year time deposits generate interest expense over the next
year, but the level of the interest generated will not change if the general level of interest rates
change. Thus, we classify these items as fixed-rate liabilities.

The five repriced liabilities ($37.50 + $50 + $25 + $75 + $25) sum to $212.5 million, and the
four repriced assets of $62.50 + $37.50 + $43.75 + $50 sum to $193.75 million. Given this, the
cumulative one-year repricing gap (CGAP) for the bank is:

CGAP = (One-year RSA) - (One-year RSL) = RSA - RSL = $193.75 million - $212.5 million =
-$18.80 million

b. Calculate the expected change in the net interest income for the bank if interest rates
rise by 1 percent on both RSAs and RSLs. If interest rates fall by 1 percent on both
RSAs and RSLs.

The CGAP would project the expected annual change in net interest income (NII) of the bank is:
NII = CGAP x R
= (-$18.80 million) x 0.01
= -$188,000

Similarly, if interest rates fall equally for RSAs and RSLs, NII will fall by:
= (-$18.80 million) x (-0.01)
= $188,000

c. Calculate the expected change in the net interest income for the bank if interest rates
rise by 1.2 percent on RSAs and by 1 percent on RSLs. If interest rates fall by 1.2
percent on RSAs and by 1 percent on RSLs.

The resulting change in NII is calculated as:

 NII = [RSA x RRSA] - [RSL x RRSL]
= [$193.75 million x 1.2%] - [$212.5 million x 1.0%]
= $2.325 million - $2.125 million
= $200,000

10. What are the reasons for not including demand deposits as rate-sensitive liabilities in the
repricing analysis for a commercial bank? What is the subtle but potentially strong reason
for including demand deposits in the total of rate sensitive liabilities? Can the same
argument be made for passbook savings accounts?

The regulatory rate available on demand deposit accounts is zero. Although many banks are able
to offer NOW accounts on which interest can be paid, this interest rate seldom is changed and
thus the accounts are not really interest rate sensitive. However, demand deposit accounts do pay
implicit interest in the form of not charging fully for checking and other services. Further, when
market interest rates rise, customers draw down their demand deposit accounts, which may cause
the bank to use higher cost sources of funds. The same or similar arguments can be made for
passbook savings accounts.

11. What is the gap to total assets ratio? What is the value of this ratio to interest rate risk
managers and regulators?

The gap to total assets ratio is the ratio of the cumulative gap position to the total assets of the FI.
The cumulative gap position is the sum of the individual gaps over several time buckets. The
value of this ratio is that it tells the direction of the interest rate exposure and the scale of that
exposure relative to the size of the FI.

12. Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test?

3-month U.S. Treasury bills Yes

1-year U.S. Treasury notes Yes
20-year U.S. Treasury bonds No
20-year floating-rate corporate bonds with annual repricing Yes
30-year floating-rate mortgages with repricing every two years No
30-year floating-rate mortgages with repricing every six months Yes
Overnight fed funds Yes
9-month fixed-rate CDs Yes
1-year fixed-rate CDs Yes
5-year floating-rate CDs with annual repricing Yes
Common stock No

13. What is the spread effect?

The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has
on net interest income as interest rates change. The spread effect is such that, regardless of the
direction of the change in interest rates, a positive relation exists between changes in the spread
and changes in NII. Whenever the spread increases (decreases), NII increases (decreases).
14. A bank manager is quite certain that interest rates are going to fall within the next six
months. How should the bank manager adjust the bank’s six-month repricing gap and
spread to take advantage of this anticipated rise? What if the manger believes rates will rise
in the next six months.

When interest rates are expected to fall, a bank should set its repricing gap to a negative position.
Further, the manager would want to increase the spread between the return on RSAs and RSLs.
In this case, as rates fall, interest income will fall by less than interest expense. The result is an
increase in net interest income. When interest rates are expected to rise, a bank should set its
repricing gap to a positive position. Again, the manager would want to increase the spread
between the return on RSAs and RSLs. In this case, as rates rise, interest income will rise by
more than interest expense. The result is an increase in net interest income.

16. Use the following information about a hypothetical government security dealer named M.
P. Jorgan. Market yields are in parenthesis, and amounts are in millions.

Assets Liabilities and Equity

Cash $10 Overnight repos $170
1-month T-bills (7.05%) 75 Subordinated debt
3-month T-bills (7.25%) 75 7-year fixed rate (8.55%) 150
2-year business loans (7.50%) 50
8-year mortgage loans (8.96%) 100
5-year munis (floating rate)
(8.20% reset every 6 months) 25 Equity 15
Total assets $335 Total liabilities & equity $335

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall
that cash is a non-interest-earning asset.

Repricing gap using a 30-day planning period = $75m - $170m = -$95 million.
Repricing gap using a 3-month planning period = ($75m + $75m) - $170m = -$20 million.
Reprising gap using a 2-year planning period = ($75m + $75m + $50m + $25m) - $170m =
+$55 million.

b. What is the impact over the next 30 days on net interest income if interest rates increase
50 basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will decrease by $475,000.
NII = CGAP(R) = -$95m(0.005) = -$0.475m.

If interest rates decrease by 75 basis points, net interest income will increase by $712,500. NII
= CGAP(R) = -$95m(-0.0075) = $0.7125m.
 c. The following one-year runoffs are expected: $10 million for two-year business loans
and $20 million for eight-year mortgage loans. What is the one-year repricing gap?

The repricing gap over the 1-year planning period = ($75m. + $75m. + $10m. + $20m. +
$25m.) - $170m. = +$35 million.

d. If runoffs are considered, what is the effect on net interest income at year-end if interest
rates increase 50 basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will increase by $175,000. NII =
CGAP(R) = $35m(0.005) = $0.175m.

If interest rates decrease 75 basis points, net interest income will decrease by $262,500. NII =
CGAP(R) = $35m(-0.0075) = -$0.2625m.

17. A bank has the following balance sheet:

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $550,000 7.75% Rate sensitive $375,000 6.25%
Fixed rate 755,000 8.75 Fixed rate 805,000 7.50
Nonearning 265,000 Nonpaying 390,000
Total $1,570,000 Total $1,570,000

Suppose interest rates rise such that the average yield on rate-sensitive assets increases by
45 basis points and the average yield on rate-sensitive liabilities increases by 35 basis
points.

a. Calculate the bank’s CGAP and gap ratio.

Repricing GAP = $550,000 - $375,000 = $175,000

Gap ratio = $175,000/$1,570,000 = 11.15%

b. Assuming the bank does not change the composition of its balance sheet, calculate the
resulting change in the bank’s interest income, interest expense, and net interest income.

II = $550,000(0.0045) = $2,475

IE = $375,000(0.0035) = $1,312.50
NII = $2,475 - $1,312.50 = $1,162.50

c. Explain how the CGAP and spread effects influenced the change in net interest income.

The CGAP affect worked to increase net interest income. That is, the CGAP was positive while
interest rates increased. Thus, interest income increased by more than interest expense. The result
is an increase in NII. The spread effect also worked to increase net interest income. The spread
increased by 10 basis points. According to the spread affect, as spread increases, so does net
interest income.
18. A bank has the following balance sheet:

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $550,000 7.75% Rate sensitive $575,000 6.25%
Fixed rate 755,000 8.75 Fixed rate 605,000 7.50
Nonearning 265,000 Nonpaying 390,000
Total $1,570,000 Total $1,570,000

Suppose interest rates fall such that the average yield on rate-sensitive assets decreases by
15 basis points and the average yield on rate-sensitive liabilities decreases by 5 basis
points.

a. Calculate the bank’s CGAP and gap ratio.

CGAP = $550,000 - $575,000 = -$25,000

Gap ratio = -$25,000/$1,570,000 = -1.59%

b. Assuming the bank does not change the composition of its balance sheet, calculate the
resulting change in the bank’s interest income, interest expense, and net interest income.

II = $550,000(-0.0015) = -$825

IE = $575,000(-0.0005) = -$287.50
NII = -$825 – (-$287.50) = -$537.50

c. The bank’s CGAP is negative and interest rates decreased, yet net interest income
decreased. Explain how the CGAP and spread effects influenced this decrease in net
interest income.

The CGAP affect worked to increase net interest income. That is, the CGAP was negative while
interest rates decreased. Thus, interest income decreased by less than interest expense. The result
is an increase in NII. The spread effect, on the other hand, worked to decrease net interest
income. The spread decreased by 10 basis points. According to the spread affect, as spread
decreases, so does net interest income. In this case, the increase in NII due to the CGAP effect
was dominated by the decrease in NII due to the spread effect.

19. The balance sheet of A. G. Fredwards, a government security dealer, is listed below.
Market yields are in parentheses, and amounts are in millions.

Assets Liabilities and Equity

Cash $20 Overnight repos $340
1-month T-bills (7.05%) 150 Subordinated debt
3-month T-bills (7.25%) 150 7-year fixed rate (8.55%) 300
2-year T-notes (7.50%) 100
8-year T-notes (8.96%) 200
5-year munis (floating rate)
 (8.20% reset every 6 months) 50 Equity 30
Total assets $670 Total liabilities and equity $670

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years?

Repricing gap using a 30-day planning period = $150m - $340m = -$190 million.
Repricing gap using a 3-month planning period = ($150m + $150m) - $340m = -$40 million.
Repricing gap using a 2-year planning period = ($150m + $150m + $100m + $50m) - $340m =
$110 million.

b. What is the impact over the next three months on net interest income if interest rates on
RSAs increase 50 basis points and on RSLs increase 60 basis points?

II = ($150m. + $150m.)(0.005) = $1.5m.

IE = $340m.(0.006) = $2.04m.
NII = $1.5m. – ($2.04m.) = -$0.54m.

c. What is the impact over the next two years on net interest income if interest rates on
RSAs increase 50 basis points and on RSLs increase 75 basis points?

II = ($150m. + $150m. + $100m. + $50m.)(0.005) = $2.25m.

IE = $340m.(0.0075) = $2.04m.
NII = $2.25m. – ($2.04m.) = $0.21m.

d. Explain the difference in your answers to parts (b) and (c). Why is one answer a
negative change in NII, while the other is positive?

For the 3-month analysis, the CGAP affect worked to decrease net interest income. That is, the
CGAP was negative while interest rates increased. Thus, interest income increased by less than
interest expense. The result is a decrease in NII. For the 3-year analysis, the CGAP affect worked
to increase net interest income. That is, the CGAP was positive while interest rates increased.
Thus, interest income increased by more than interest expense. The result is an increase in NII.

20. A bank has the following balance sheet:

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $225,000 6.35% Rate sensitive $300,000 4.25%
Fixed rate 550,000 7.55 Fixed rate 505,000 6.15
Nonearning 120,000 Nonpaying 90,000
Total $895,000 Total $895,000

Suppose interest rates rise such that the average yield on rate-sensitive assets increases by
45 basis points and the average yield on rate-sensitive liabilities increases by 35 basis
points.

a. Calculate the bank’s repricing GAP.

Repricing GAP = $225,000 - $300,000 = -$75,000

b. Assuming the bank does not change the composition of its balance sheet, calculate the
net interest income for the bank before and after the interest rate changes. What is the
resulting change in net interest income?

NIIb = ($225,000(0.0635) +$550,000(0.0755)) – ($300,000(0.0425) + $505,000(0.0615))

= $55,812.50 - $43,807.50 = $12,005

NIIa = ($225,000(0.0635 + 0.0045) +$550,000(0.0755)) – ($300,000(0.0425 + 0.0035) +

$505,000(0.0615)) = $56,825 - $44,857.50 = $11,967.50

NII = $11,967.50 - $12,005 = -$37.50

c. Explain how the CGAP and spread effects influenced this increase in net interest
income.

The CGAP affect worked to decrease net interest income. That is, the CGAP was negative while
interest rates increased. Thus, interest income increased by less than interest expense. The result
is a decrease in NII. In contrast, the spread effect worked to increase net interest income. The
spread increased by 10 basis points. According to the spread affect, as spread increases, so does
net interest income. However, in this case, the increase in NII due to the spread effect was
dominated by the decrease in NII due to the CGAP effect.

21. What are some of the weakness of the repricing model? How have large banks solved the
problem of choosing the optimal time period for repricing? What is runoff cash flow, and
how does this amount affect the repricing model’s analysis?

The repricing model has four general weaknesses:

(1) It ignores market value effects.

(2) It does not take into account the fact that the dollar value of rate-sensitive assets and
liabilities within a bucket are not similar. Thus, if assets, on average, are repriced earlier in
the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks.

(3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities
are withdrawn before the maturity date.

(4) It ignores income generated from off-balance-sheet activities.

Large banks are able to reprice securities every day using their own internal models so
reinvestment and repricing risks can be estimated for each day of the year.
Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are
withdrawn unexpectedly. To the extent that either of these amounts is significantly greater than
expected, the estimated interest rate sensitivity of the FI will be in error.