First American Bank has the following market value balance sheet structure: Assets Liabilities and Equity Cash $2,000

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Question:

First American Bank has the following market value balance sheet structure:

Assets Liabilities and Equity

Cash $2,000 Certificate of deposit $10,000

Bond $10,000 Equity $2,000

Total assets $12,000 Total liabilities and equity $12,000

1.The bond has a 10-year maturity, a fixed-rate coupon of 8 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a one-year maturity and a 5 percent rate of interest. The FI expects no additional asset growth. What will be the net interest income at the end of the first year? Note: Net interest income equals interest income minus interest expense. (2 marks)

2.If at the end of year 1 market interest rates have decreased 50 basis points (0.5 percent), what will be the net interest income for the second year? Is this result caused by reinvestment risk or refinancing risk? (2 marks)

3.If market interest rates increase 1 percent, the bond will have a value of $9,650 at the end of year 1. What will be the market value of the equity for the FI? Assume that all the NII in part (a) is used to cover operating expenses or dividends. (2 marks)

4.If market interest rates had decreased 200 basis points by the end of year 1, would the market value of equity be higher or lower than $2,000?Why? (2 marks)