Unit 2: Risk in Banking Business

Questions and problems

1. The First State Bank of Gregsville reports a net interest margin of 2.5
percent in its most recent financial report, with total interest revenue of
$88 million and total interest costs of $72 million. What volume of earning
assets must the bank hold? Suppose the banks interest revenues rise by
8 percent and its interest costs and earning assets increase 9 percent.
What will happen to Gregsvilles net interest margin?
2. First National Bank of Bannerville has posted interest revenues of $63
million and interest costs from all of its borrowings of $42 million. If this
bank possesses $700 million in total earning assets, what is First
Nationals net interest margin? Suppose the banks interest revenues and
interest costs double, while its earning assets increase by 50 percent.
What will happen to its net interest margin? [3%, 4%]
3. If a banks net interest margin, which was 2.50 percent, increases 70
percent and its total assets, which stood originally at $545 million, rise by
40 percent, what change will occur in the banks net interest income?
4. Can you explain the concept of gap management?
5. When is a financial firm asset sensitive? Liability sensitive?
6. Commerce National Bank reports interest-sensitive assets of $870 million
and Interest-sensitive liabilities of $625 million during the coming month.
Is the bank asset sensitive or liability sensitive? What is likely to happen
to the banks net interest margin if interest rates rise? If they fall?
7. Clarksville Financial reports a net interest margin of 2.75 percent in its most recent
financial report with total interest revenues of $95 million and total
interest costs of $82 million. What volume of earning assets must the
bank hold? Suppose the banks interest revenues rises by 5 percent and
its interest costs and earnings assets increase by 9 percent. What will
happen to Clarksvilles net interest margin? [2.01 percent]
8. If a credit unions net interest margin, which was 2.50 percent, increases
15 percent and its total assets, which stood originally at $625 million, rise
by 20 percent, what change will occur in the bank's net interest income?
[$21.5625 million]
9. A financial firm holds a bond in its investment portfolio whose duration is
13.5 years. Its current market price is $950. While market interest rates
are currently at 7 percent for comparable quality securities, a decrease in
interest rates to 6.75 percent is expected in the coming weeks. What
changes (in percentage terms) will this bonds price experience if market
interest rates change as anticipated? [3.15 percent]
10. Peoples Savings Bank, a thrift institution, has a cumulative gap for the coming year of +
$135 million and interest rates are expected to fall by two and a half percentage points. Can
you calculate the expected change in net interest income that this thrift institution might
experience? What change will occur in net interest income if interest rates rise by one and a
quarter percentage points? [-$3.38 million, +$1.69 million]

11. Old Misers State Bank has recorded the following financial data for the
past three years (dollars in millions)

What has been happening to the banks net interest margin? What do you
think caused the changes you have observed? Do you have any
recommendations for Old Misers management team? [2.33% each year]
12. The First National Bank of Sylvania finds that its asset and liability
portfolio contains the following distribution of maturities and repricing
opportunities:

When and by how much is the bank exposed to interest rate risk? For
each maturity or repricing interval, what changes in interest rates will be
beneficial to the bank and which will be damaging, given its current
portfolio position?
13. Suppose Carroll Bank and Trust reports interest-sensitive assets of
$570 million and interest-sensitive liabilities of $685 million. What is the
banks dollar interest-sensitive gap? Its relative interest-sensitive gap and
interest-sensitivity ratio? [Gap = -$115, Relative Gap = -20.18%, Interestsensitive ratio = 0.8321]
14. How is a financial institutions duration gap determined?
15. How can you tell you are fully hedged using duration gap analysis?
16. Suppose that a thrift institution has an average asset duration of 2.5
years and an average liability duration of 3.0 years. If the thrift holds total
assets of $560 million and total liabilities of $467 million, does it have a

significant leverage-adjusted duration gap? If interest rates rise, what will

happen to the value of its net worth?
17. Mountaintop Savings Association has interest-sensitive assets of $300
million, interest sensitive liabilities of $175 million, and total assets of
$500 million. What is the banks dollar interest-sensitive gap? What is
Mountaintops relative interest-sensitive gap? What is the value of its
interest sensitivity ratio? Is it asset sensitive or liability sensitive? Under
what scenario for market interest rates will Mountaintop experience a gain
in net interest income? A loss in net interest income?
18. Casio Merchants and Trust Bank, N.A., has a portfolio of loans and
securities expected to generate cash inflows for the bank as follow:

Deposits and money market borrowings are expected to require the

following cash outflows:

If the discount rate applicable to the previous cash flows is 8 percent,

what is the duration of Casios portfolio of earning assets and of its
deposits and money market borrowings? What will happen to the banks
value of equity, assuming all other factors are held constant, if interest
rates rise? If interest rates fall? Given the size of the duration gap you
have calculated, in what type of hedging should Casio engage? Please be
specific about the hedging transactions that are needed and their
expected effects.
19. Given the cash inflow and outflow figures in Problem 18 for Casio
Merchants and Trust Bank, N.A., suppose that interest rates began at a
level of 8 percent and then suddenly rise to 9 percent. If the bank has
total assets of $125 million, and total liabilities of $110 million, by how

much would the value of Casios net worth change as a result of this
movement in interest rates? Suppose, on the other hand, that interest
rates decline from 8 percent to 7 percent. What happens to the value of
Casios net worth in this case and by how much in dollars does it change?
What is the size of its duration gap?
20. Watson Thrift Association reports an average asset duration of 5 years
and an average liability duration of 4.25 years. In its latest financial
report, the association recorded total assets of $1.8 billion and total
liabilities of $1.5 billion. If interest rates began at 7 percent and then
suddenly climbed to 9 percent, what change will occur in the value of
Watsons net worth? By how much would Watsons net worth change if,
instead of rising, interest rates fell from 7 percent to 5 percent? [change
in net worth = -$109.31 million, + $72.88 million]
21. A bank holds a bond in its investment portfolio whose duration is 13.5
years. Its current market price is $1,020. While market interest rates are
currently at 8 percent for comparable quality securities, a decrease in
interest rates to 7.25 percent is expected in the coming weeks. What
change (in percentage terms) will this bonds price experience if market
interest rates change as anticipated?
22. Stilwater Bank and Trust Company has an average asset duration of
3.25 years and an average liability duration of 1.75 years. Its liabilities
amount to $485 million, while its assets total $512 million. Suppose that
interest rates were 7 percent and then rise to 8 percent. What will happen
to the value of the Stilwater bank's net worth as a result of a decline in
interest rates? [Duration gap = + 1.5923 years, change in net worth = $7.62 million.]
23. A savings banks weighted average asset duration is seven years. Its
total liabilities amount to $900 million, while its assets total 1 billion
dollars. What is the dollar-weighted duration of the banks liability
portfolio if it has a zero leverage-adjusted duration gap? [10.81years]
24. New Phase National Bank holds assets and liabilities whose average
durations and dollar amounts are as shown in this table:

What is the weighted-average duration of New Phases asset portfolio and

liability portfolio? What is its leverage-adjusted duration gap?
25. A government bond currently carries a yield to maturity of 8 percent
and a market price of $1,080. If the bond promises to pay $100 in interest
annually for five years, what is its current duration?

26. Dewey National Bank holds $15 million in government bonds having a

duration of six years. If interest rates suddenly rise from 6 percent to 7

percent, what percentage change should occur in the bonds market
price?