BANK3011 Workshop Week 4 – Suggested End of Chapter 9 Solutions + more

1. What is the difference between book value accounting and market value accounting?
How do interest rate changes affect the value of bank assets and liabilities under the
two methods? What is marking to market?

Book value accounting reports assets and liabilities at the original issue values. Current
market values may be different from book values because they reflect current market
conditions, such as interest rates or other market prices. This is especially a problem if an
asset or liability has to be liquidated by the FI. If the asset or liability is held until
maturity, then the reporting of book values may not be seen as a problem because it ties
back to reported accounting income. Book value accounting is the basis of the Repricing
Model.
For an FI, a major factor affecting asset and liability values is interest rate changes. If
interest rates increase, the value of loans (assets) fall and deposits and debt (liabilities)
rise. If assets and liabilities are held until maturity, it does not affect the book valuation
of the FI. However, if deposits or loans have to be refinanced, then market value
accounting presents a better picture of the financial condition of the FI.
The process by which changes in the economic value of assets and liabilities are accounted
is called marking to market. It should be noted that the changes in markets can be in
aggregate beneficial as well as detrimental to the total economic health of the FI. This is
the basis of the Maturity Model.

2. Consider a five-year, 15 per cent bond annual coupon bond with a face value of $1,000.
The bond is trading at a market yield to maturity of 8 percent (just for revision)

a. What is the price of the bond? (Assume the bond is priced at the coupon date)
PV = $150*PVIFAi=8%,n=5 + $1,000*PVIFi=8%,n=5 = $1,279.49
b. If the market yield to maturity increases 1 percent, what will be the bond’s new
price?
PV = $150*PVIFAi=9%,n=5 + $1,000*PVIFi=9%,n=5 = $1,233.38
c. Using your answers to parts (a) and (b), what is the percentage change in the
bond’s price as a result of the 1 percent increase in interest rates?
P = ($1,233.38 - $1,279.49)/$1,279.49 = –3.60 percent.
3. a) Calculate the duration of a two-year $100,000 bond that pays an annual coupon
rate of 10 per cent if today’s yield to maturity is 14 per cent.
b) What is the expected change in the price of the bond if interest rates decline by
0.5%pa (i.e. 50 basis points) using the standard bond pricing methodology?
c) Use duration to calculate the approximate price change if interest rates decline by 50
basis points.
d) Is there a difference between the value calculated in (b) and (c)? If so, why are they
different?
e) What would the duration be if today’s yield to maturity was 13.5 per cent? Is your
answer different to that in (a)? If so why? (Not from Text)

(a) If current yields are 14.0%

Years No. of Periods Cashflow Present Value PV x Years
1 1 10 8.772 8.772
2 2 110 84.641 169.283
93.413 178.055

Duration = 178.055 / 93.413 = 1.9061 years

(b) Price @ 14%pa yield = $93.413 per $100. Total price = $100,000 x 93.413 / 100 =
$93,413.00
Price @ 13.5%pa yield = $94.199 per $100. Total price = $100,000 x 94.199 / 100 =
$94,199.00
Change in Price $94,199.00 - $93,413 = $786.00
(c) The Change in price using duration would be assessed as:
∆P = -D x ∆r /(1+r) x P
= -1.9061 x -0.005/(1.14) x $93,413.00
= $780.93
(d) Yes the result differs by approximately $5.07. This result is due to the impact of
convexity on the change in price. Duration does not account for the impact of
convexity because duration is a linear approximation of the non-linear price valuation
function.
(e) If current yields are 13.5%
Years No. of Periods Cashflow Present Value PV x Years
1 1 10 8.811 8.811
2 2 110 85.389 170.778
94.199 179.588

Duration = 179.588 / 94.199 = 1.9065 years

 At a lower interest rate the security is effectively a little longer. This means that the
risk profile of the security has increased. The 4th rule of fixed income indicates that at
lower absolute levels of interest rates (i.e. 13.5% p.a. is lower than the current market
rate of 14% p.a.) a given change in yields will result in a larger change in the price of
the security, i.e. the security is more risky. This rule is reflected in the duration
calculation at the new interest rate.

26. The following balance sheet information is available (amounts in $ thousands and
duration in years) for a financial institution
Amount Duration
Commercial bills $90 0.50
T-notes 55 0.90
T-bonds 176 x
Loans 2,724 7.00
Deposits 2,092 1.00
Federal funds 238 0.01
Equity 715
Treasury bonds are 5-year maturities paying 6 percent semi-annually and selling at par.
a. What is the duration of the T-bond portfolio?
b. What is the average duration of all the assets?
c. What is the average duration of all the liabilities?
d. What is the leverage-adjusted duration gap? What is the interest rate risk
exposure?
e. If the entire yield curve shifted upward by 50 basis points [i.e., R/(1+R) =
0.0050], what would be the impact on the FI’s market value of equity?
f. If the entire yield curve shifted downward by 25 basis points [i.e., R/(1+R) =
0.0025], what would be the impact on the FI’s market value of equity?
g. What variables are available to the financial institution to immunize the balance
sheet? How much would each variable need to change to get DGAP equal to 0?
(a) The duration of the Treasury bond portfolio is:
No. Periods CF PV PV/P×t

1 3 2.91 0.029
2 3 2.83 0.057
3 3 2.75 0.083
4 3 2.67 0.107
5 3 2.59 0.13
6 3 2.51 0.15
7 3 2.44 0.17
8 3 2.37 0.189
9 3 2.30 0.207
10 103 76.64 7.664

100 8.79 half years = 4.393 years

(b) The weighted average of the FI’s asset durations is:

90 55 176 2724
(0.5) + (0.9) + (4.393) + ( 7) = 6.55 years
3045 3045 3045 3045
(c) The weighted average of the FI’s liability durations is:
2092 238
(1) + (0.01) = 0.90 years
2330 2330
(d) The FI’s duration gap is:
2330
DG = DA − kDL = 6.55 − (0.90) = +586
. years
3045
(e) The impact on the FI's market value of equity of a 50 basis point increase in all
interest rates is:
R
MVE  −DG(A) = −5.86(3045 )(0.0050 ) = −$89.22
1+ R
If all interest rates increase at a rate of 0.5%, then the FI’s market value of equity can be
89 220
expected to decrease by a value of $89,220. This is an equity loss of =-12.5%.
715 000
(f) The impact on the FI’s market value of equity of a 25 basis point decrease in all
interest rates is:
R
MVE  − DG( A) = −5.86($3045 m)(−0.0025 ) = +$44 610
1+ R
If all interest rates decrease at a rate of 0.25%, the FI’s market value of equity can be
expected to increase by a value of $44 610. This is an equity gain of
44 610
= +6.24% .
715 000

(g) Immunisation requires the bank to have a leverage-adjusted duration gap of 0.0.
Therefore, the FI could reduce the duration of its assets to 0.689 years
(0.9*2330/3045) by investing in more T-notes and floating rate loans. Or the FI could
try to increase the duration of its deposits possibly by using fixed-rate CDs with a
maturity of 3 or 4 years. Finally, the FI could use a combination of reducing asset
duration and increasing liability duration in such a manner that LADG is 0.0. This
duration gap of 5.86 years is quite large and it is not likely that the FI will be able to
reduce it to zero by using only balance sheet adjustments. For example, even if the FI
moved all of its loans into T-bills, the duration of the assets still would exceed the
duration of the liabilities after adjusting for leverage. This adjustment in asset mix
would imply foregoing a large yield advantage from the loan portfolio relative to the
T-bill yields in most economic environments, and therefore would be impractical.