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FIN 4100 Financial Institution Management

Fall 2014

Vaughn Armstrong

Due October 28, 2014


This assignment is open book and open note. You may consult other books, articles, or internet sites (provided the sites do not respond to specific questions you pose).


On questions that require calculations, you may receive partial credit for answers that are not wholly correct if you include your calculations.  On questions that ask for an explanation, do not write more than is necessary to articulate your reasoning or reflect your understanding of the specific topic of the question. Please clearly state any additional assumptions you make.


1. (10 points) A bond has a market value of $1225.75 and a duration of 4.36.  If the yield on the bond increases from 2.85% to 3.25%, how much is the value of the bond expected to change?


2. (20 points) Identify the regulator(s) that has principal regulatory authority with respect to (a) commercial banks and (b) investment banks in the United States. (Note: It may be the case that more than one regulator should be included in part a and/or part b.)  For each regulator, indicate what the general objective of its regulation is, and specify one regulatory requirement designed to accomplish that objective.


3. (10 points) Describe how a financial institution might use migration analysis to manage the credit risk of its loan portfolio.


4. (15 points) Provide a brief description of each of the following line items from a depository institution’s balance sheet, including whether the line item refers to an asset and/or a liability of the financial institution, what type of entity the counter-party is, how the line item is created, and what the typical maturity and requirements for payment are.

a. Repurchase agreement

b. Commercial loan

c. Treasury bill

d. Cash

e. Deposit

f. Federal fund

g. Commercial paper

h. Reserve

i. Subordinated note

j. Equity


5. (10 points) Whatcontractual rate (base rate plus risk premium) will a financial institution charge for a $75 million loan if all of the following are true:

i. The financial institution needs an expected return of 6.15% in order to cover its costs of funds and overhead and to generate a desired profit for its investors.

ii. The expected default rate on loans of this type is 4%.

iii. If there is a loan default, the financial institution still expects to recover 80% of the amount it would receive in the absence of a default.

iv. The lender charges an origination fee of 0.375% of the loan amount.

v. The lender requires the borrower to maintain a compensating balance during the full term of the loan in an amount equal to 12.5% of the loan balance.

vi. The lender maintains a reserve balance of 12.5%.


6. (10 points)What contractual rate (base rate plus risk premium) will a financial institution charge for a $75 million loan if all of the following are true:

i. The lender has a minimum risk adjusted return on capital of 37.5%. Capital subject to risk is calculated using the rate adjustment for the worst 5% of loans.

ii. The loan has a duration of 6.12 years.

iii. The lender’s cost of funds is 2.35%.

iv. There is a 0.65% origination fee on the loan.

v. Loans with comparable risk yield 7.25%.

vi. For a recent period, the rate adjustment for the worst 5% of loans with comparable risk due to changes in credit risk was 65 basis points.


7. (10 points)

a. Explain what is meant by the term intermediation and identify two types of intermediation that financial institutions utilize.

b. What effect does financial intermediation have on a financial market?


8. (15 points)

a. Explain why the manager of a commercial bank is concerned about gap management.

b. If a bank manager who relies on the pure expectations theory to explain the term structure of interest rates expects higher inflation to begin in approximately two years,how does the manager expect short and long term interest rates to change?

c. What actions should the manager from part b take in response to this expected change?


9. (10 points) A company has assets with a current value of $728 billion dollars and a debt, due in 4 years, that has a principal balanceof $402 billion.  If the company expects its asset value to grow by 4% each year and the standard deviation of monthly returns on the company’s stock is 7.75%, what is the probability that the company will default on the loan?


10. (40 points)What is the duration of each of the following? Assume the yield to maturity in each case is 5.25%.

a. Abond that makes a fixed semi-annual coupon payment of $28.25 which represents 2.35% of its par value and never repays the principal.

b. An 18-year bond with a par value of $1000 and 14 years remaining until maturity that pays a 4.95% annual coupon.

c. A 25-year, zero coupon bond with a face value of $5000.

d. A portfolio that includes 100 of each of the bonds from part a, b and c.


11. (20 points)

a. What is one important way that the assets of a depository institution differ from those of an investment bank/securities firm?

b. What is one important way that the liabilities of a depository institution differ from those of an investment bank/securities firm?

c. What is the most important source of income for a depository institution?

d. What is the most important source of income for an investment bank/securities firm?


12. (30 points)

a. Explain how the information revealed by a bank’s duration gap differs from that provided by its re-pricing gap.

b. A bank has assets with a total value of $4.67 billion; $4.22 billion of the assets are rate sensitive. The bank’s liabilities total $4.11 billion, all of which are rate sensitive.  If the average duration of its asset portfolio is 4.87 years and its liabilities have a 3.51-year average duration, what is the bank’s leverage adjusted duration gap?

c. What is the expected dollar and percentage change in the value of the bank’s equity if the average interest rate is expected to increase from 3.75% to 3.95%?




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