Question 1

11 marks

five (5) questions. Answer all questions.

ABC Financial Institution (FI) has assets of $500 million, which consists of $400 million 2- year commercial loans with a 10 percent annual fixed rate selling at par and $100 million 1- year zero coupon bonds. The assets are financed with equity and $450 million 1-year certificates of deposit (CDs) with a 7% annual fixed rate selling at par.

a. What is the leverage-adjusted duration gap of the FI?

b. What is the impact on the net worth of the FI if the relative change in all market interest rates is a decrease of 40 basis points? Note: The relative change in interest rates is R/(1+R) = - 0.004.

c. What is the impact on the net worth of the FI if the relative change in all market interest rates is an increase of 50 basis points?

d. What would the duration of the CDs need to be in order to immunize the net worth of the FI from changes in market interest rates?

e. What can be said about the desired leverage-adjusted duration gap for financial institutions if interest rates are expected to increase or decrease?