Solutions For End-of-Chapter Questions and Problems: Chapter Eight
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
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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.
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.
Yes. This change will increase RSAs, which will increase GAP.
No. This change will decrease RSAs, which will decrease GAP.
No. This change will increase RSLs, which will decrease GAP.
No. This change will have no impact on either RSAs or RSLs. So, will have no impact on GAP.
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
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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.
a. Calculate the repricing gap and the impact on net interest income of a 1 percent
increase in interest rates for each position.
b. Calculate the impact on net interest income on each of the above situations assuming a
1 percent decrease in interest rates.
c. What conclusion can you draw about the repricing model from these results?
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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
(1-year maturity) 2. Demand deposits 50.00
3. Long-term consumer loans 31.30
(2-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 43.70 5. Three-month bankers’
acceptances 25.00
6. 3-year T-bonds 75.00 6. Six-month commercial paper 75.00
7. 10-year, fixed-rate mortgages 25.00 7. 1-year time deposits 25.00
8. 30-year, floating-rate mortgages
(reset every nine months) 50.00 8. 2-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: $43.70 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 $193.70 million. The remaining $143.80
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 $131.30 million in long-term consumer loans, 3-year Treasury bonds, and
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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. 1-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 + $43.70 + $50 sum to $193.70 million. Given this, the
cumulative one-year repricing gap (CGAP) for the bank is:
CGAP = (One-year RSA) - (One-year RSL) = RSA - RSL = $193.70 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.
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The resulting change in NII is calculated as:
NII = [RSA x RRSA] - [RSL x RRSL]
= [$193.70 million x 1.2%] - [$212.5 million x 1.0%]
= $2.3244 million - $2.125 million
= $199,400
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 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?
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
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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.
15. Consider the following balance sheet for WatchoverU Savings, Inc. (in millions):
b. What will expected net interest income be if interest rates rise today by 2 percent?
After the 2 percent interest rate increase, net interest income is:
50(0.12) + 50(0.07) - 70(0.08) - 20(.07) = $9.5m - $7.0m = $2.5m, a decline of $0.4m.
c. Using the cumulative repricing gap model, what is the expected net interest income for
a 2 percent increase in interest rates?
WatchoverU’s repricing or funding gap is $50m - $70m = -$20m. The change in net interest
income using the funding gap model is (-$20m)(0.02) = -$0.4m.
d. What will expected net interest income over the next year if interest rates on RSAs
increase by 2 percent but interest rates on RSLs increase by 1 percent? Is it reasonable
for changes in interest rates on RSAs and RSLs to differ? Why?
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After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) –
70(0.07) – 20(0.07) = $9.5m - $6.3m = $3.2m, an increase of $0.3m. It is not uncommon for
interest rates to adjust in an unequal manner on RSAs versus RSLs. Interest rates often do not
adjust solely because of market pressures. In many cases, the changes are affected by decisions
of management. Thus, you can see the difference between this answer and the answer for part a.
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.
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?
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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.
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.
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.
c. Explain how the CGAP and spread effects influence 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.
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.
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.
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.
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.
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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?
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 60 basis points?
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 2-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.
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.
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?
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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
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?
(2) It ignores information regarding the distribution of assets and liabilities within time
buckets. 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.
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.
The following questions and problems are based on material in Appendix 8A, located on the
website (www.mhhe.com/saunders10e).
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22. What is a maturity gap? How can the maturity model be used to immunize an FI’s
portfolio? What is the critical requirement that allows maturity matching to have some
success in immunizing the balance sheet of an FI?
Maturity gap is the difference between the average maturity of an FI’s assets and liabilities. If the
maturity gap is zero, it is possible to immunize the portfolio so that changes in interest rates will
result in equal but offsetting changes in the value of assets and liabilities. Thus, if interest rates
increase (decrease), the fall (rise) in the value of the assets will be offset by an identical fall (rise)
in the value of the liabilities. The critical assumption is that the timing of the cash flows on the
assets and liabilities must be the same.
23. Nearby Bank has the following balance sheet (in millions):
What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or
decrease in interest rates? Explain why?
24. County Bank has the following market value balance sheet (in millions, all interest at
annual rates). All securities are selling at par equal to book value.
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b. What will be the maturity gap if the interest rates on all assets and liabilities increase by
1 percent?
If interest rates increase one percent, the value and average maturity of the assets will be:
Cash = $20m
Commercial loans = $16mxPVAn=15, i=11% + $160mxPVn=15,i=11% = $148.49m
Mortgages = $24mxPVAn=30,i=9% + $300mxPVn=30,i=9% = $269.18m
MA = [0x$20m + 15x$148.49m + 30x$269.18m]/($20m + $148.49m + $269.18m) =
23.54 years
The maturity gap = MGAP = 23.54 – 7.74 = 15.80 years. The maturity gap increased because the
average maturity of the liabilities decreased more than the average maturity of the assets. This
result occurred primarily because of the differences in the cash flow streams for the mortgages
and the debentures.
The market value of the assets has decreased from $480m to $437.67m, or $42.33m. The market
value of the liabilities has decreased from $430m to $409.61m, or $20.39m. Therefore, the
market value of the equity will decrease by $42.33m - $20.39m = $21.94m, or 43.88 percent.
25. If a bank manager is certain that interest rates were going to increase within the next six
months, how should the bank manager adjust the bank’s maturity gap to take advantage of
this anticipated increase? What if the manager believes rates will fall? Would your
suggested adjustments be difficult or easy to achieve?
When rates rise, the value of the longer-lived assets will fall by more the shorter-lived liabilities.
If the maturity gap is positive, the bank manager will want to shorten the maturity gap or make it
negative. If the maturity gap is negative, the manager might do nothing. If rates are expected to
decrease, the manager should reverse these strategies. Changing the maturity on the balance
sheet often involves changing the mix of assets and liabilities. Attempts to make these changes
may involve changes in financial strategy for the bank which may not be easy to accomplish.
Later in the text, methods of achieving the same results using derivatives will be explored.
26. An insurance company has invested in the following fixed-income securities: (a)
$10,000,000 of five-year Treasury notes paying 5 percent interest and selling at par value,
(b) $5,800,000 of 10-year bonds paying 7 percent interest with a par value of $6,000,000,
and (c) $6,200,000 of 20-year subordinated debentures paying 9 percent interest with a par
value of $6,000,000.
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a. What is the weighted-average maturity of this portfolio of assets?
b. If interest rates change so that the yields on all of the securities decrease 1 percent, how
does the weighted-average maturity of the portfolio change?
To determine the weighted-average maturity of the portfolio for a rate decrease of 1 percent, the
new value of each security must be determined. This calculation will require knowing the yield
to maturity of each security before the rate change.
T-notes are selling at par, so the yield to maturity = 5 percent. Therefore, the new value will be
PV = $500,000xPVAn=5,i=4% + $10,000,000xPVn=5,i=4% = $10,445,182.
10-year bonds: Par = $6,000,000, PV = $5,800,000, Cpn = 7 percent YTM = 7.485%. The
new PV = $420,000xPVAn=10,i=6.485% + $6,000,000xPVn=10,i=6.485% = $6,222,161.
Debentures: Par = $6,000,000, PV = $6,200,000, Cpn = 9 percent 8.644 percent. The new PV
= $540,000xPVAn=20,i=7.644% + $6,000,000xPVn=20,i=7.644 = $6,820,378.
The total value of the assets after the change in rates will be $23,487,721, and the weighted-
average maturity will be [5x$10,445,182 + 10x$6,222,030 + 20x$6,820,378]/$23,487,721 =
250,855,080/23,487,721 = 10.68 years.
c. Explain the changes in the weighted-average maturity of the portfolio if the yields
increase by 1 percent.
When interest rates increase 1 percent, the value of the T-note is $9,578,764, the value of the 10-
year bond is $5,414,885, and the value of the debenture is $5,662,851, and the new value of the
assets is $20,656,500. The weighted-average maturity is 10.42 years.
d. Assume that the insurance company has no other assets. What will be the effect on the
market value of the company’s equity if the interest rate changes in (b) and (c) occur?
Assuming that the company is financed entirely with equity, the market value will increase
$1,487,721 when interest rates decrease 1 percent, and the market value will decrease $1,343,500
when rates increase 1 percent. Notice that for the same absolute rate change, the increase in value
is greater than the decrease in value.
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The average maturity of loans is four years and the average maturity of deposits is two
years. Assume loan and deposit balances are reported as book value, zero-coupon items.
a. Assume that interest rate on both loans and deposits is 9 percent. What is the market
value of equity?
The market value of loans = $1,000/(1.09)4 = $708.4252, and the market value of deposits =
$850/(1.09)2 = $715.4280. The net worth = $708.4252 - $715.4280 = -$7.0028. (That is, net
worth is negative.)
b. What must be the interest rate on deposits to force the market value of equity to be
zero? What economic market conditions must exist to make this situation possible?
In this case the deposit value should equal the loan value. Thus, $850/(1 + x)2 = $708.4252.
Solving for x, we get 9.5374%. That is, deposit rates will have to increase more because they
have a shorter maturity. Further, this result suggests that deposit rates would have to be higher
than loan rates.
c. Assume that interest rate on both loans and deposits is 9 percent. What must be the
average maturity of deposits for the market value of equity to be zero?
In this case, we need to solve the equation in part (b) for N, i.e., $850/(1 + 0.09)N = $708.4252.
The result is N = 2.1141 years. If interest rates remain at 9 percent, then the average maturity of
deposits has to be higher in order to match the value of a 4-year loan.
28. Gunnison Insurance has reported the following balance sheet (in thousands):
All securities are selling at par equal to book value. The two-year notes are yielding 5
percent, and the 15-year munis are yielding 9 percent. The one-year commercial paper pays
4.5 percent, and the five-year notes pay 8 percent. All instruments pay interest annually.
d. What does your answer to part (c) imply about the interest rate exposure of Gunnison
Insurance?
Gunnison Insurance is exposed to interest rate risk. If interest rates rise, net worth will decrease
because the average maturity of the assets is higher than the average maturity of the liabilities.
The opposite holds true if interest rates fall. That is, net worth will increase.
e. Calculate the values of all four securities on Gunnison Insurance’s balance sheet
assuming that all interest rates increase 2 percent. What is the dollar change in the total
asset and total liability values? What is the percentage change in these values?
f. What is the dollar impact on the market value of equity for Gunnison? What is the
percentage change in the value of the equity?
g. What would be the impact on Gunnison’s market value of equity if the liabilities paid
interest semiannually instead of annually?
The value of liabilities will be lower with semi-annual compounding, increasing the value of net
worth. The one-year CP will decline in value to $132.43. The five-year note will decline in value
to $147.64. The value of equity will decrease to $29.87 = ($168.67 + $141.27) - ($132.43 +
$147.64).
29. Scandia Bank has issued a one-year, $1million CD paying 5.75 percent to fund a one-year
loan paying an interest rate of 6 percent. The principal of the loan will be paid in two
installments: $500,000 in six months and the balance at the end of the year.
a. What is the maturity gap of Scandia Bank? According to the maturity model, what does
this maturity gap imply about the interest rate risk exposure faced by Scandia Bank?
The maturity gap is 1 year – 1 year = 0. The maturity gap model would state that the bank is
immunized against changes in interest rates because assets and liabilities are of equal maturity.
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b. Assuming no change in interest rates over the year, what is the expected net interest
income at the end of the year?
c. What would be the effect on annual net interest income of a 2 percent interest rate
increase that occurred immediately after the loan was made? What would be the effect
of a 2 percent decrease in rates?
If interest rates increase 2 percent, then the reinvestment benefits of cash flows in six months
will be higher:
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Principal and interest paid on deposits ($1,000,000 x 0.0575) $1,057,500
Net income received -$1,900
d. What do these results indicate about the ability of the maturity model to immunize
portfolios against interest rate exposure?
The results indicate that just matching assets and liabilities by maturity is not sufficient to
immunize a portfolio against interest rate risk. If the timing of the cash flows within a period is
different for assets and liabilities, the effects of interest rate changes are different. For a truly
effective immunization strategy, one also needs to account for the timing of cash flows.
30. EDF Bank has a very simple balance sheet. Assets consist of a two-year, $1 million loan
that pays an interest rate of LIBOR plus 4 percent annually. The loan is funded with a two-
year deposit on which the bank pays LIBOR plus 3.5 percent interest annually. LIBOR
currently is 4 percent, and both the loan and the deposit principal will be paid at maturity.
c. Immediately prior to the beginning of year 2, LIBOR rates increased to 6 percent. What
is the expected net interest income in year 2? What would be the effect on net interest
income of a 2 percent decrease in LIBOR?
Year 2: If interest rates increase 2 percent Year 2: If interest rates decrease 2 percent
Interest received in year 2 $100,000 Interest received in year 2 $60,000
Interest paid in year 2 95,000 Interest paid in year 2 55,000
Net interest income in year 2 $5,000 Net interest income in year 2 $5,000
d. What do the answers to parts (b) and (c) of this question suggest about the use of
maturity gap to immunize an FI against interest rate risk?
The solutions above suggest that, as long as the FI’s assets are financed entirely with liabilities
and the timing of the cash flows on the assets and liabilities of the FI are perfectly matched,
setting the maturity gap equal to zero immunizes the FI against interest rate risk.
First, the maturity gap model does not consider the degree of leverage on the balance sheet. For
example, if assets are not financed entirely with deposits, a change in interest rates may cause the
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assets to change in value by a different amount than the liabilities. Second, the maturity model
does not take into account the timing of the cash flows of either the assets or the liabilities, and
thus reinvestment and/or refinancing risk may become important factors in profitability and
valuation as interest rates change.
The following questions and problems are based on material in Appendix 8B to the chapter.
32. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill
rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
Using the unbiased expectations theory, calculate the current (long-term) rates for one-,
two-, three-, and four-year-maturity Treasury securities. Plot the resulting yield curve.
1 R1 = 6.00%
and the current yield to maturity curve will be upward sloping as shown:
Yield to Maturity
7.09%
6.83%
6.50%
6.00%
_____________________________ Term to Maturity
0 1 2 3 4 (in years)
33. The current one-year Treasury bill rate is 5.2 percent and the expected one-year rate 12
months from now is 5.8 percent. According to the unbiased expectations theory, what
should be the current rate for a two-year Treasury security?
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34. The Wall Street Journal reported interest rates of 6 percent, 6.35 percent, 6.65 percent, and
6.75 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively.
According to the unbiased expectations theory, what are the expected one-year rates for
years 4, 5, and 6?
35. The Wall Street Journal reports that the rate on three-year Treasury securities is 5.60
percent and the rate on four-year Treasury securities is 5.65 percent. According to the
unbiased expectations hypothesis, what does the market expect the one-year Treasury rate
to be in year 4, E(4r1)?
36. How does the liquidity premium theory of the term structure of interest rates differ from the
unbiased expectations theory? In a normal economic environment, that is, an upward-
sloping yield curve, what is the relationship of liquidity premiums for successive years into
the future? Why?
The unbiased expectations theory asserts that long-term rates are a geometric average of current
and expected short-term rates. The liquidity premium theory asserts that long-term rates are a
geometric average of current and expected short-term rates plus a liquidity risk premium. The
premium is assumed to increase with the maturity of the security because the uncertainty of
future returns grows as maturity increases.
37. Based on economists= forecasts and analysis, one-year Treasury bill rates and liquidity
premiums for the next four years are expected to be as follows:
1R1 = 5.65%
Using the liquidity premium hypothesis, plot the current yield curve. Make sure you label
the axes on the graph and identify the four annual rates on the curve both on the axes and
on the yield curve itself.
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1 R1 = 5.65%
Yield to Maturity
6.67% ∙
6.47% ∙
6.22% ∙
5.65% ∙
_____________________________ Term to Maturity
0 1 2 3 4 (in years)
38. The Wall Street Journal reports that the rate on three-year Treasury securities is 5.25
percent and the rate on four-year Treasury securities is 5.50 percent. The one-year interest
rate expected in year four, E(4r1), is 6.10 percent. According to the liquidity premium
hypothesis, what is the liquidity premium on the four-year Treasury security, L4?
1R4 = [(1+1R1)(1+E(2r1)+L2)(1+E(3r1)+L3)(1+E(4r1)+L4)]1/4-1
39. You note the following yield curve in The Wall Street Journal. According to the unbiased
expectations hypothesis, what is the one-year forward rate for the period beginning two
years from today, 2f1?
Maturity Yield
One day 2.00%
One year 5.50
Two years 6.50
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Three years 9.00
f = [(1.065)2/(1.055)] - 1 = 7.51%
2 1
State Bank’s balance sheet is listed below. Market yields are in parenthesis, and amounts are in
millions.
a. What is the repricing gap if the planning period is 30 days? 6 months? 1 year? 2 years? 5
years?
Assets Repricing period
Cash $20 Not rate sensitive
Fed funds (1.05%) 150 30-days
3-month T-bills (5.25%) 150 6-months
2-year T-notes (6.50%) 100 2-years
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8-year T-bonds (7.50%) 200 Not rate sensitive
5-year munis (floating rate)
(8.20%, repriced @ 6 months) 50 6-months
6-month consumer loans (6%) 250 6-months
1-year consumer loans (5.8%) 300 1-year
5-year car loans (7%) 350 5-years
7-month C&I loans (5.8%) 200 1-year
2-year C&I loans (floating rate)
(5.15%, repriced @ 6-months) 275 6-months
15-year variable rate mortgages
(5.8%, repriced @ 6-months) 200 6-months
15-year variable rate mortgages
(6.1%, repriced @ year) 400 1-year
15-year fixed-rate mortgages (7.85%) 300 Not rate sensitive
30-year variable rate mortgages
(6.3%, repriced @ quarter) 225 6-months
30-year variable rate mortgages
(6.4%, repriced @ month) 355 30-days
30-year fixed-rate mortgages (8.2%) 400 Not rate sensitive
Premises and equipment 20 Not rate sensitive
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RSLs = $875m. + $120m. + $220m. + $300m. = $1515m.
CGAP = $1655m. - $1515m. = $140m.
1-year repricing gap: RSAs = $1655m. + $300m. + $200m. + $400m. = $2555m.
RSLs = $1515m. + $375m. = $1890m.
CGAP = $2555m. - $1890m. = $665m.
2-year repricing gap: RSAs = $2555m. + $100m. = $2655m.
RSLs = $1890m. + $425m. = $2315m.
CGAP = $2655m. - $2315m. = $340m.
5-year repricing gap: RSAs = $2655m. + $350m. = $3005m.
RSLs = $2315m. + $330m. + $350m. + $200m. = $3195m.
CGAP = $3005m. - $3195m. = -$190m.
b. What is the impact over the next six months on net interest income if interest rates on RSAs
increase 60 basis points and on RSLs increase 40 basis points?
c. What is the impact over the next year on net interest income if interest rates on RSAs increase
60 basis points and on RSLs increase 40 basis points?
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