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Financial Institutions Management A Risk Management Approach 8th edition Marcia Cornett, Patricia McGraw, Anthony Saunders - Solutions

What are long-term mutual funds? In what assets do these funds usually invest? What factors caused the strong growth in this type of fund from 1992 through 2007, the slowdown in growth in 2007-2008, and the return to growth after 2008?
Using the data in Table 5-2, discuss the growth and ownership holdings over the last 32 years of long-term funds versus short-term funds.
Why did the proportion of equities in long-term funds increase from 38.3 percent in 1990 to more than 70 percent by 2000, and then decrease to 54 percent in 2012? How might an investor’s preference for a mutual funds objectives change over time?
How does the risk of short-term funds differ from the risk of long-term funds?
What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors? Why do individuals rather than corporations hold most mutual funds?
What are the principal demographics of household owners who own mutual funds? What are the primary reasons why household owners invest in mutual funds?
What change in regulatory guidelines occurred in 2009 that had the primary purpose of giving investors a better understanding of the risks and objectives of a fund?
What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution?
Contrast the balance sheet of a life insurance company (Table 6-3) with the balance sheet of a commercial bank (Table 2-6) and that of a savings institution (Table 2-10). Explain the balance sheet differences in terms of the differences in the primary functions of the three organizations.
Using the data in Table 6-2, how has the composition of assets of U.S. life insurance companies changed over time?
How would the balance sheet of a life insurance company change if it offered to run a private pension fund for another company?
How does the regulation of insurance companies differ from the regulation of depository institutions? What are the major pieces of life insurance regulatory legislation?
How do state guarantee funds for life insurance companies compare with deposit insurance for depository institutions?
How have the product lines of property-casualty insurance companies changed over time?
Contrast the balance sheet of a property-casualty insurance company (Table 6-5) with the balance sheet of a commercial bank (Table 2-6). Explain the balance sheet differences in terms of the differences in the primary functions of the two organizations.
What are the three sources of underwriting risk in the property-casualty insurance industry?
How do unexpected increases in inflation affect property-casualty insurers?
Identify the four characteristics or features of the perils insured against by property-casualty insurance. Rank the features in terms of actuarial predictability and total loss potential.
Insurance companies will charge a higher premium for which of the insurance lines listed below? Why?
Consider the data in Table 6-6. Since 1980, what has been the necessary investment yield for the industry to enable the operating ratio to be less than 100 in each year? How is this requirement related to the interest rate risk and credit risk faced by a property-casualty insurer?
a. What is the combined ratio for a property insurer that has a loss ratio of 73 percent, a loss adjustment expense of 12.5 percent, and a ratio of commissions and other acquisition expenses of 18 percent? b. What is the combined ratio adjusted for investment yield if the company earns an
An insurance company’s projected loss ratio is 77.5 percent and its loss adjustment expense ratio is 12.9 percent. The company estimates that commission payments and dividends to policyholders will be 16 percent. What must be the minimum yield on investments to achieve a positive operating ratio?
An insurance company collected $3.6 million in premiums and disbursed $1.96 million in losses. Loss adjustment expenses amounted to 6.6 percent and dividends paid to policyholders totaled 1.2 percent. The total income generated from the company’s investments was $170,000 after all expenses were
You deposit $12,000 annually into a life insurance fund for the next 10 years, at which time you plan to retire. Instead of a lump sum, you wish to receive annuities for the next 20 years. What is the annual payment you expect to receive beginning in year 11 if you assume an interest rate of 6
a. Suppose a 65-year-old person wants to purchase an annuity from an insurance company that would pay $20,000 per year until the end of that person’s life. The insurance company expects this person to live for 15 more years and would be willing to pay 6 percent on the annuity. How much should the
Corporate bonds usually pay interest semiannually. If a company decided to change from semiannual to annual interest payments, how would this affect the bond’s interest rate risk?
Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zero-coupon bond that pays only a lump-sum payment
Consider again the two bonds in problem 11. If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this risk?
What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk?
Many banks and savings institutions that failed in the 1980s had made loans to oil companies in Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional economy, and the banks and savings institutions all experienced financial problems. What types of risk were inherent
What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
What is market risk? How does this risk affect the operating performance of financial institutions? What actions can be taken by an FI’s management to minimize the effects of this risk?
Consider these four types of risks: credit, foreign exchange, market, and sovereign. These risks can be separated into two pairs of risk types in which each pair consists of two related risk types, with one being a subset of the other. How would you pair off the risk types, and which risk type
Consider an FI that issues $200 million of liabilities with two years to maturity to finance the purchase of $200 million of assets with a one year maturity. Suppose that the cost of funds (liabilities) for the FI is 5 percent per year and the interest return on the assets is 9 percent per year.
How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIs?
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.b. What
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 month days? 2 years? b. What is the impact over the next three months on net
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?
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?
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
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
The following is a simplified FI balance sheet: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
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
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?
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
What are the weaknesses of the maturity gap model?
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: 1R1=6% E(2r1) =7% E(3r1) =7.5% E(4r1)=7.85%
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?
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?
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)?
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%E(2r1) = 6.75%L2 = 0.05%E(3r1) = 6.85%L3 = 0.10%E(4r1) = 7.15%L4 = 0.12%
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
State Bank€™s balance sheet is listed below. Market yields and durations (in years) are in parenthesis, and amounts are in millions.a. What is State Bank€™s duration gap?b. Use these duration values to calculate the expected change in the value of the assets and liabilities of State Bank
State Bank's balance sheet is listed below. Market yields and durations (in years) are in parenthesis, and amounts are in millions.a. What is the repricing gap if the planning period is six months? One year?b. What is State Bank€™s duration gap?c. What is the impact over the next six months on
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?
An insurance company is analyzing three bonds and is using duration as the measure of interest rate risk. All three bonds trade at a yield to maturity of 10 percent, have $10,000 par values, and have five years to maturity. The bonds differ only in the amount of annual coupon interest that they
You can obtain a loan of $100,000 at a rate of 10 percent for two years. You have a choice of (i) paying the interest (10 percent) each year and the total principal at the end of the second year or (ii) amortizing the loan, that is, paying interest (10 percent) and principal in equal payments each
You have discovered that the price of a bond rose from $975 to $995 when the yield to maturity fell from 9.75 percent to 9.25 percent. What is the duration of the bond?
A 10-year, 10 percent annual coupon, $1,000 bond trades at a yield to maturity of 8 percent. The bond has a duration of 6.994 years. What is the modified duration of this bond? What is the practical value of calculating modified duration? Does modified duration change the result of using the
What is dollar duration? How is dollar duration different from duration?
Calculate the duration of a two-year, $1,000 bond that pays an annual coupon of 10 percent and trades at a yield of 14 percent. What is the expected change in the price of the bond if interest rates fall by 0.50 percent (50 basis points)?
The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semiannual coupon and selling at par has been estimated at 6.763 years. a. What is the modified duration of the bond? What is the dollar duration of the bond?b. What will be the estimated price change on the bond if interest
Suppose you purchase a six-year, 8 percent coupon bond (paid annually) that is priced to yield 9 percent. The face value of the bond is $1,000.a. Show that the duration of this bond is equal to five years.b. Show that if interest rates rise to 10 percent within the next year and your investment
Suppose you purchase a five-year, 15 percent coupon bond (paid annually) that is priced to yield 9 percent. The face value of the bond is $1,000.a. Show that the duration of this bond is equal to four years.b. Show that if interest rates rise to 10 percent within the next year and your investment
What are the two different general interpretations of the concept of duration, and what is the technical definition of this term? How does duration differ from maturity?
Consider the case in which an investor holds a bond for a period of time longer than the duration of the bond, that is, longer than the original investment horizon.a. If interest rates rise, will the return that is earned exceed or fall short of the original required rate of return? Explain.b. What
If an FI uses only duration to immunize its portfolio, what three factors affect changes in the net worth of the FI when interest rates change? The change in net worth for a given change in interest rates is given by the following equation:
Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94 years. The assets are financed with equity and a $900,000, two-year, 7.25 percent semiannual coupon capital note
The balance sheet for Gotbucks Bank, Inc. (GBI), is presented below ($ millions):Notes to the balance sheet: The fed funds rate is 8.5 percent, the floating loan rate is LIBOR + 4 percent, and currently LIBOR is 11 percent. Fixed rate loans have five-year maturities, are priced at par, and pay 12
Hands Insurance Company issued a $90 million, one-year note at 8 percent add-on annual interest (paying one coupon at the end of the year) or with an 8 percent yield. The proceeds were used to fund a $100 million, two-year commercial loan with a 10 percent coupon rate and a 10 percent yield.
The following balance sheet information is available (amounts in thousands of dollars and duration in years) for a financial institution:Treasury bonds are five-year maturities paying 6 percent semiannually and selling at par.a. What is the duration of the T-bond portfolio? b. What is the average
Assume that a goal of the regulatory agencies of financial institutions is to immunize the ratio of equity to total assets, that is, ( (E/A) = 0. Explain how this goal changes the desired duration gap for the institution. Why does this differ from the duration gap necessary to immunize the total
Identify and discuss three criticisms of using the duration gap model to immunize the portfolio of a financial institution.
In general, what changes have occurred in the financial markets that would allow financial institutions to restructure their balance sheets more rapidly and efficiently to meet desired goals? Why is it critical for an FI manager who has a portfolio immunized to match a desired investment horizon to
A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12 percent. The loan requires payment of accrued interest and one-half of the principal at the end of six months. The remaining principal and accrued interest are due at the end of the year.a. What will be the cash
A financial institution has an investment horizon of two years 9.33 months (or 2.777 years). The institution has converted all assets into a portfolio of 8 percent, $1,000, three-year bonds that are trading at a yield to maturity of 10 percent. The bonds pay interest annually. The portfolio
Consider a five-year, 15 percent annual coupon bond with a face value of $1,000. The bond is trading at a yield to maturity of 12 percent.a. What is the price of the bond?b. If the yield to maturity increases 1 percent, what will be the bond’s new price?c. Using your answers to parts (a) and
Consider a $1,000 bond with a fixed-rate 10 percent annual coupon rate and a maturity (N) of 10 years. The bond currently is trading at a yield to maturity (YTM) of 10 percent. a. Complete the following table:b. Use this information to verify the principles of interest rate-price relationships for
MLK Bank has an asset portfolio that consists of $100 million of 30-year, 8 percent coupon, $1,000 bonds that sell at par. a. What will be the bonds’ new prices if market yields change immediately by ( 0.10 percent? What will be the new prices if market yields change immediately by ( 2.00
Estimate the convexity for each of the following three bonds, all of which trade at yield to maturity of 8 percent and have face values of $1,000.A 7-year, zero-coupon bond.A 7-year, 10 percent annual coupon bond.A 10-year, 10 percent annual coupon bond that has a duration value of 6.994 years
Two bonds are available for purchase in the financial markets. The first bond is a two-year, $1,000 bond that pays an annual coupon of 10 percent. The second bond is a two-year, $1,000, zero-coupon bond.a. What is the duration of the coupon bond if the current yield-to-maturity (R) is 8 percent?10
What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual coupon selling at par? Selling with a yield to maturity of 12 percent? 14 percent? What can you conclude about the relationship between duration and yield to maturity? Plot the relationship. Why does this
Consider three Treasury bonds each of which has a 10 percent semiannual coupon and trades at par.a. Calculate the duration for a bond that has a maturity of four years, three years, and two years?b. What conclusions can you reach about the relationship of duration and the time to maturity? Plot the
A six-year, $10,000 CD pays 6 percent interest annually and has a 6 percent yield to maturity. What is the duration of the CD? What would be the duration if interest were paid semiannually? What is the relationship of duration to the relative frequency of interest payments?
What is a consol bond? What is the duration of a consol bond that sells at a yield to maturity of 8 percent? 10 percent? 12 percent? Would a consol trading at a yield to maturity of 10 percent have a greater duration than a 20-year zero-coupon bond trading at the same yield to maturity? Why?
Maximum Pension Fund is attempting to manage one of the bond portfolios under its management. The fund has identified three bonds which have five year maturities and trade at a yield to maturity of 9 percent. The bonds differ only in that the coupons are 7 percent, 9 percent, and 11 percent.a. What
County Bank offers one-year loans with a stated rate of 9 percent, but requires a compensating balance of 10 percent. What is the true cost of this loan to the borrower? How does the cost change if the compensating balance is 15 percent? If the compensating balance is 20 percent? In each case,
Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25 percent loan origination fee, imposes a 10 percent compensating balance requirement, and must hold a 6 percent reserve requirement at the Federal Reserve. The loans typically are repaid at maturity. a. If the risk
Why are most retail borrowers charged the same rate of interest, implying the same risk premium or class? What is credit rationing? How is it used to control credit risks with respect to retail and wholesale loans?
Why could a lender’s expected return be lower when the risk premium is increased on a loan? In addition to the risk premium, how can a lender increase the expected return on a wholesale loan? A retail loan?
What are covenants in a loan agreement? What are the objectives of covenants? How can these covenants be negative? Positive?
Identify and define the borrower-specific and market-specific factors that enter into the credit decision. What is the impact of each type of factor on the risk premium? The borrower-specific factors are: Reputation: Based on the lending history of the borrower; better reputation implies a lower
Why is the degree of collateral as specified in the loan agreement of importance to a lender? If the book value of the collateral is greater than or equal to the amount of the loan, is the credit risk of a lender fully covered? Why, or why not?
Why are FIs consistently interested in the expected level of economic activity in the markets in which they operate? Why is monetary policy of the Federal Reserve System important to FIs?
Suppose there were two factors influencing the past default behavior of borrowers: the leverage or debt–assets ratio (D/A) and the profit margin ratio (PM). Based on past default (repayment) experience, the linear probability model is estimated as: PDi = 0.105(D/Ai ) - 0.35(PMi ) Prospective
Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error, where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower earnings, and X3 = 0.10 is the borrower’s profit ratio.
Describe how a linear discriminant analysis model works. Identify and discuss the criticisms which have been made regarding the use of this type of model to make credit risk evaluations.
Suppose that the financial ratios of a potential borrowing firm take the following values: Working capital/total assets ratio (X1) = 0.75 Retained earnings/total assets ratio (X2) = 0.10 Earnings before interest and taxes/total assets ratio (X3) = 0.05 Market value of equity/book value of
MNO Inc., a publicly traded manufacturing firm in the United States, has provided the following financial information in its application for a loan. All numbers are in thousands of dollars.Also assume sales = $500,000; cost of goods sold = $360,000; and the market value of equity is equal to the

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