FIN3101A/FIN3701A: Corporate Finance

QUESTION 1 a

Use this balance sheet information to answer the following questions:

Financial Institution (FI) Balance Sheet (Amount in millions, Duration in years)
Assets Amount Duration Liabilities Amount Duration
Cash 50 ? Core Deposits 750 1.25 yrs
Treasury Bonds 350 2.25 yrs CDs 300 1.00 yrs
Loans (special) 650 ? Euro CDs ? 0.75 yrs
Loans (fixed) 750 3.75 yrs Equity 150

The bank is considering approving a special loan with the following characteristics:

Loan A: The loan that has 5 years to maturity and has bond-like repayments.

Loan B: The loan has repayments of $145.808 million at the end of year 1, $603.695 million at the end of year 4, and $33.755 million at the end of year 6.

Both loans are trading at par and the yield to maturity is 5.5 percent per annum.

Select the loan that the bank should approve. Please provide justification. Assume that both loans have similar default risks.

Assuming a flat yield curve and a parallel shift of the entire yield curve of 150-basis points upward what the impact on the FI’s market value of equity is?

QUESTION 1b

Calculate the convexity for a three-year 5.5% coupon rate with a face value of $500,000 loan with amortized payments.

Use this information to determine the impact on the market value of the amortized loan if the entire yield curve shifts 150-basis points upward.

What is the usefulness of convexity when duration is available as a measure of interest rate risk? What is the practical implication for the three-year loan in this example?

QUESTION 2a

The figure below shows the federal funds rate for the period 2012 to 2022. The federal funds rate is the interest rate banks charge each other to borrow or lend excess reserves overnight.

As can be seen, the rate is rapidly rising. What impact does this have on commercial banks’ net interest margin? Be specific by considering the banks’ assets, liabilities, and equity.

QUESTION 2b

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? How does this impact runoff?

QUESTION 3a (i) 

Following are current prices for pure discount bonds with face value of $1,250 of different maturities as of 1 January 2022. Calculate the spot interest rates for each bond.

Bond Maturity Price Bond Maturity Price
1 year $1,190.48 3 years $1,049.52
2 years $1,123.07 4 years $ 953.62

QUESTION 3a (ii)

Assume the expectations theory is valid. Based on your results in part (a), determine the spot 1-year, 2-year, and 3-year rates expected 1 year later on 1 January 2023.

QUESTION 3b

In corporate finance, the leverage ratio can be calculated by dividing capital by book value of assets. How have regulators altered this ratio to determine the capital adequacy requirements for banks or authorized depository institutions?

QUESTION 4a

Explain the arguments for and against market-value accounting. In your answer ensure that you clearly explain “real losses” and “paper losses” and the role of moral hazard in the application of market value accounting. Use a simplified bank balance sheet to illustrate your response. How would the impact of COVID-19 influence your answer?

QUESTION 4b

 A financial institution has the following balance:

Balance Sheet (in billion)
Assets Liabilities
Cash 18 Deposits 140
Government securities 18 Borrowed Funds 20
Other Assets 164 Equity 40
Total 200 Total 200

In 2022 a flood increased liquidity needs of a bank servicing the affected community as depositors withdrew deposits to the value of $20 billion.

Withdrawal of Deposits
Assets Liabilities
Cash Deposits
Government securities Borrowed Funds
Other Assets Equity
Total Total

 Would you recommend this bank rely more on asset liquidity or liability liquidity to meet these additional requirements? Give reasons. Show how you would manage the bank’s liquidity position.