Exercises Federica Ielasi 2010 October 28

Exercise Rank the following bank assets from most to least liquid: – Commercial loans – Securities – Reserves – Physical capital

Sol Reserves Securities Commercial loans Physical capital

Exercise If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans?

Sol You should want to make short-term loans. Then, when these loans mature, you will be able to make loans at higher interest rates, which will generate more income for the bank.

Exercise If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE?

Sol To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds. Northern Rock ROE at the end of 2006 = 23,5%!!

Exercise One problem for investors in long-term coupon bonds, even when investors have a long holding period, is that there is some uncertainty in their returns arising from what is called reinvestment risk. Even if an investor holding a long-term coupon bond has a holding period of 10 years, the return on the bond is not certain: the coupon payments must be reinvested. In contrast, long-term zero-coupon bonds have no reinvestment risk because they make no cash payments before the bond matures. The return on a zero-coupon bond if it is held to maturity is known at the time of purchase.

Exercise The investors are willing to accept a slightly lower interest rate on zero-coupon bonds than on coupon bonds Banks can separate (“strip”) a long-term coupon bond into a set of zero-coupon bonds A $ 1,000, year Treasury bond might be stripped into ten $ 100,000 zero coupon bonds: Treasury strip zero-coupon bonds

Exercise Coupon rate of Treasury bond = 10% Yield to maturity = 10% Interest rate on the zero-coupon bonds = 9.75%

Exercise YearCash paymentInterest rate on ZCBPresent value of ZCB 1100, , , , , , , , , , , , , , , , , , , , ,000, ,416

Sol The total present discounted value of zero- coupon bonds is $ 1,015,528… … which is greater than the $ 1,000,000 purchase price of the Treasury bond.

Exercise Assets 2010 Liabilities 2010 Interest-earning assets 2,500,000 Interest-costing liabilities 2,000,000 Non interest-earning assets 700,000 Non interest-costing liabilities 1,200,000 Real estate assets 300,000 Bank capital 300,000 Total assets 3,500,000 Total liabilities 3,500,000 INCOME STATEMENT 2010 Interest income 180,000 - interest expenses 130,000 = Net Interest profits 50,000 Net profits 40,000

Sol ROE = 13,33% Positive interest rate = 7,2% Negative interest rate = 6,5% Working capital = 500,000