Question 1 [11 marks]

Consider the following balance sheet for MMC Bancorp (in millions of dollars):

1.  Equity capital (fixed)

2.  Demand deposits

3.  One-month CDs

4.  Three-month CDs

5.  Three-month bankers’ acceptances

6.  Six-month commercial

7.  1-year time deposits

8.  2-year time deposits

a.   Calculate the value of MMC’s rate-sensitive assets, rate sensitive liabilities, and cumulative gap over the next year. What does the gap suggest?

b.   If interest rates rise by 1 percent on both RSAs and RSLs, calculate the expected change in the net interest income for the FI

c.   If interest rates rise by 1.2 percent on RSAs and by 1 percent on RSLs, calculate the change in the spread and what does the spread suggest?

d.   Calculate the expected change in the net interest income for the FI.

e.    Explain how the CGAP and spread effects influence the change in net interest income.

Question 2 [11 marks]

A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent.

a.   Using the RAROC model, determine whether the bank should make the loan?

b.   What should be the duration in order for this loan to be approved?

c.   Assuming that duration cannot be changed, how much additional interest and fee income will be necessary to make the loan acceptable?

d.   Given the proposed income stream and the negotiated duration, what adjustment in the loan rate would be necessary to make the loan acceptable?

Question 3 [11 marks]

Consider $100 million of 30-year mortgages with a coupon of 5 percent per year paid quarterly.

a.   What is the quarterly mortgage payment?

b.   What are the interest and principal repayments over the first year of life of the mortgages?

c.   Construct a 30-year CMO using this mortgage pool as collateral. The pool has three     tranches, where tranche A offers the least protection against prepayment and tranche C offers the most protection against prepayment. Tranche A of $25 million receives        quarterly payments at 4 percent per year, tranche B of $50 million receives quarterly   payments at 5 percent per year, and tranche C of $25 million receives quarterly            payments at 6 percent per year.

d.   Assume nonamortization of principal and no prepayments. What are the total promised coupon payments to the three classes? What are the principal payments to each of the   three classes for the first year?

e.   If, over the first year, the trustee receives quarterly prepayments of $5 million on the mortgage pool, how are these funds distributed?

f.   How are the cash flows distributed if prepayments in the first half of the second year are $10 million quarterly?

Question 4 [11 marks]

A. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of capital.

a. If the average historical losses in the automobile sector total 8 percent, what is the           maximum loan a manager can lend to firms in this sector as a percentage of total capital?

b.   If the average historical losses in the mining sector total 15 percent, what is the                maximum loan a manager can lend to firms in this sector as a percentage of total capital?

B.    Suppose that an FI holds two loans with the following characteristics.

Loan 1  2

Spread between   Loan Rate and FI’s

Xi Cost of Funds

0.45                  5.5%

0.55                  3.5

Fees

2.25%

1.75

Loss to FI

Given

Default 30%   20

Expected

Default

Frequency

3.5%

1.0

Calculate of the return and risk on the two-asset portfolio using Moody’s Analytics Portfolio Manager.

Question 5 [11 marks]

Hedge Row Bank has the following balance sheet (in millions):

Assets $150 Liabilities                      $135

Equity 15

Total $150 Total $150

The duration of the assets is six years and the duration of the liabilities is four years. The interest rate on both the assets and the liabilities is 10 percent. The bank is expecting interest rates to fall from 10 percent to 9 percent over the next year.

a.   What is the duration gap for Hedge Row Bank?

b.   What is the expected change in net worth for Hedge Row Bank if the forecast is accurate?

c.   What will be the effect on net worth if interest rates increase 110 basis points?

d.   If the existing interest rate on the liabilities is 6 percent, what will be the effect on net worth of a 1 percent increase in interest rates?