Homework Set #4 solutions (22 points total)

1. a. [2 pts ] Macauley duration of the first loan is 2.859 years and the second loan is : 1.937 years, as per the work below
below.

spot
rates

5%
t
1
2
3

spot
rates
t
1
2
3

CFt
5
5
105

DFt
0.952
0.907
0.864
present
value
macauley
dur

5%
principal
P
interest I
33.33
5.0000
33.33
3.3333
33.33
1.6667

CF x DFt
4.762
4.535
90.703

CFt x DFt x
t
4.762
9.070
272.109

100

285.941

2.859

P+I =
CFt
38.33
36.67
35.00

DFt
0.9524
0.9070
0.8638
present
value
macauley
dur

CF x DFt
36.508
33.258
30.234

CFt x DFt x
t
36.508
66.515
90.703

100.000

193.726

1.937

b.[1 point ] The Macauley duration of the second loan is LESS because its cash flows are more evenly weighted throughout
the life of the loan (because principal is being repaid early). On a relative basis (each cash flows relative to each other), this means
that the balance point of these cash flows is LESS than a loan where the cash flows are much more skewed towards one final,
large bullet principal payment (the first loan), interspersed with relatively small interest rate payments.

2 (a) [1 pt] Macauley duration of annual pay bond is : 8.108 years, as per work below. Take this to be the duration of the liability N.
The market value of the liability is : 67.329 as per work below. The market value of equity is E= A- L = 100 67.329 = 32.671.
E/A = 32.671%

spot
rates
t
1
2
3
4
5
6

5%
CFt
5
5
5
5
5
5

DFt
0.952
0.907
0.864
0.823
0.784
0.746

CF x DFt
4.762
4.535
4.319
4.114
3.918
3.731

CFt x DFt x t
4.762
9.070
12.958
16.454
19.588
22.386

7
8
9
10

5
5
5
105

t
CFt
8.1078
22

0.711
0.677
0.645
0.614
present
value
macauley
dur

24.874
27.074
29.007
644.609

100

810.782

8.108

DFt
100

3.553
3.384
3.223
64.461

CF x DFt

0.673
present
value
macauley
dur

CFt x DFt x t

67.329

545.890

67.329

545.890

8.108

2(b) [1 pt] The new market values: A = 85.9528 L = 57.778. E = A-L = 28.175 (decrease when rates rise) and E/A = 32.780%. The
equity ratio did indeed change, even when we matched the durations. Interestingly , the capital ratio IMPROVED ! [ this is due
to the positive convexity of the assets dominating the effective negative convexity of a short position in single cash flow
liability] The work to calculate these figures is below

spot
rates
t
1
2
3
4
5
6
7
8
9
10

7%
CFt
5
5
5
5
5
5
5
5
5
105

DFt
0.9346
0.8734
0.8163
0.7629
0.7130
0.6663
0.6227
0.5820
0.5439
0.5083
present
value

CF x DFt
4.6729
4.3672
4.0815
3.8145
3.5649
3.3317
3.1137
2.9100
2.7197
53.3767

CFt x DFt x t
4.6729
8.7344
12.2445
15.2579
17.8247
19.9903
21.7962
23.2804
24.4770
533.7668

85.9528

682.0450

t
CFt
DFt
CF x DFt
CFt x DFt x t
8.1078
22
100
0.578
57.778
468.453
present
value
57.778
468.453

2(c) [1 pt] The new market values: A = 84.557 L = 56.931 as per work below. E = A-L = 27.626 (decrease when rates rise) and E/A
= 32.671%. The equity ratio to assets did NOT change, even when we matched the durations. So this is hinting at why the text
claims to set DA = DL to immunize the capital ratio, and its clear the basic assumption we had to make.

A = 100 100*(8.108)*2%/(1+5%)
= 84.557
A = 67.329 67.329*(8.108)*2%/(1+5%) = 56.931
2(d) [2 pts ] We all agree that : E= AL . Now why would these variables A or L change ? One reason is due to a change in
interest rates. As interest rates change, this statement must hold true: E= A L
Likewise, because E = A L, then E/A = 1 L/A and we can consider the potential changes in the ratio :

( E/ A )= 1(L / A) = (L/ A)
Divide both sides by

Taking limits as

R :
( E/ A )/ R = ( L/ A) / R

R0

lim ( E / A)/ R = lim ( L/ A )/ R

R 0

R 0

d E d L
=
dR A
dR A

( )

( )

since we are GIVEN

dP
=PD/(1+ R) , we have (from basic calculus) :
dR
dL
dA
A
L
d E d L
dR
dR ALD L LAD A
=
=
=
2
dR A
dR A
A
A2 (1+ R)

( )

( )

or

AL( DL D A )
d E
=
dR A
A2 (1+ R)

( )

IF you take

D L =D A , the ratio E/A will never change when R changes q.e.d.

3.
3a. [1 pt]
Five-year Loan (values in millions of $s)
Par value = $65
R = 12%
t
1
2
3
4
5

CFt
7.8
7.8
7.8
7.8
72.8

DFt
0.8929
0.7972
0.7118
0.6355
05674

Coupon rate = 12%

Maturity = 5 years
CFt x DFt
6.964
6.218
5.552
4.957
41.309
65.000

Annual payments

CFt x DFt x t
6.964
12.436
16.656
19.828
206.543
262.427

Duration = $262.427/$65.000 = 4.0373

a.

DA = [$30(0) + $20(0.36) + $105(0.36) + $65(4.0373)]/$220 = 1.3974 years

b.

[1 pt]
Two-year Core Deposits (values in millions of $s)
Par value = $20
Coupon rate = 8%
R = 8%
Maturity = 2 years
t
1
2

CFt
1.6
21.6

DFt
0.9259
0.8573

CFt x DFt
1.481
18.519

Annual payments
CFt x DFt x t
1.481
37.037

20.000

38.519

Duration = $38.519/$20.000 = 1.9259

d.

[1 pt] DL = [$20(1.9259) + $50(0.401) + $130(0.401)]/$200 = 0.5535 years

e.

[1 pt] The leveraged adjusted duration gap is: 1.3974 - 200/220 x (0.5535) = 0.8942 years
Since the duration gap is positive, an increase in interest rates will lead to a decrease in the
market value of equity.

f.

[1 pt] For a 1 percent increase, the change in equity value is:

E = -0.8942 x $220,000,000 x (0.01) = -$1,967,280 (new net worth will be $18,032,720).

g.

[1 pt] For a 0.5 percent decrease, the change in equity value is:
E = -0.8942 x (-0.005) x $220,000,000 = $983,647 (new net worth will be $20,983,647).

h.

[1 pt] Immunization requires the bank to have a leverage adjusted duration gap of 0. Therefore, Bank X could
reduce the duration of its assets to 0.5032 (0.5535 x 200/220) years by using more fed funds and floating rate loans.
Or the bank could use a combination of reducing asset duration and increasing liability duration in such a manner
that DGAP is 0.

4. a. [2 pts] ( Do not forget to weight by the total asset and total liability instead of the sum of those asset/liability with a nonzero duration)
DA = [20(0) + 150(0.02) + 300(0.22) + 200(7.55) + 900(2.50) + 475(6.58) + 1,200(19.50) + 580(0.25) + 120(0)]/3,945
= 7.73118 years
DL = [250(0) + 360(0.50) + 715(0.48) + 1,105(4.45) + 515(.02) + 400(.45) + 200(6.65))]/3,545 = 1.96354 years
DGAP = DA - kDL = 7.76369 7.73118- ($3,545/$3,945)(1.96354) = 5.96673 years
(b) [2 pts]
(Can not use the total duration of asset and liability directly, since the interest rate of each are not the same.)

MVfedfunds = -0.02 x .015/1.0505 x 150m

MVT-bills = -0.22 x .015/1.0525 x 300m
MVT-bonds = -7.55 x .015/1.0750 x 200m
MVconsumerloans = -2.50 x 0.015/1.0600 x 900m
MVC&Iloans = -6.58 x 0.015/1.0580 x 475m
MVfixed-ratemortgages = -19.50 x 0.015/1.0785 x 1,200m
MVvariable-ratemortgages = -0.25 x 0.015/1.0630 x 580m

=>MVA
MVMMDAs = -0.50 x 0.015/1.045 x 360m
MVCDs = -0.48 x 0.015/1.0430 x 715m
MVCDs = -4.45 x 0.015/1.0600 x 1,105m
MVfedfunds = -0.02 x 0.015/1.0500 x 515m
MVcommericalpaper = -0.45 x 0.015/1.0505 x 400m
MVfixed-ratesubordinatedebt = -6.65 x 0.015/1.0725 x 200m
=>MVL

=
-$42,837
-$940,618
= -$21,069,767
= -$31,839,623
= -$44,312,382
= -$325,452,017
= -$2,046,096
= -$425,703,339
= -$2,583,732
= -$4,935,762
= -$69,583,726
=
-$147,143
= -$2,570,205
= -$18,601,399
= -$98,421,967

(c) [2 pts]

MVE = MVA MVL = -$425,703,339 (-$98,421,967) = -$327,281,372

4