Consider a bank with the following balance sheet (M means million): Assets Value Duration of the Asset Convexity of the Asset 5yr bond bought at a yield of 3.4% (lending money) $550M 4.562 12.026 12yr bond bought at a yield of 4% (lending money) $800M 9.453 53.565 Liabilities Value Duration of the Liability Convexity of the Liability 2yr bond sold at a yield of 2.4% (borrowing money) $300M 1.941 2.384 4yr bond sold at a yield of 2.8% (borrowing money) $500M 3.759 8.206 Calculate the equity (total asset – total liability) to asset ratio of the bank Calculate the duration and convexity of the both asset and liability sides; If the interest rates go up by 1%, using the duration and convexity rule to determine the net worth of the bank and the equity to asset ratio; In c)’s scenario, to maintain the equity to asset ratio at 40% which is required by the regulation, the bank decides to raise cash (zero duration and zero convexity) from the equity holders. How much cash does the bank need to raise? Do you agree with the following statement? Explain why. “The information about a bond’s duration and convexity adjustment is sufficient to quantify interest rate risk exposure.”

Cornerstones of Financial Accounting

4th Edition

ISBN:9781337690881

Author:Jay Rich, Jeff Jones

Publisher:Jay Rich, Jeff Jones

Chapter12: Fainancial Statement Analysis

Section: Chapter Questions

Problem 18MCQ

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Question

Consider a bank with the following balance sheet (M means million):

Assets

Value

Duration of the Asset

Convexity of the Asset

5yr bond bought at a yield of 3.4% (lending money)

$550M

4.562

12.026

12yr bond bought at a yield of 4% (lending money)

$800M

9.453

53.565

Liabilities	Value	Duration of the Liability	Convexity of the Liability
2yr bond sold at a yield of 2.4% (borrowing money)	$300M	1.941	2.384
4yr bond sold at a yield of 2.8% (borrowing money)	$500M	3.759	8.206

Calculate the equity (total asset – total liability) to asset ratio of the bank
Calculate the duration and convexity of the both asset and liability sides;
If the interest rates go up by 1%, using the duration and convexity rule to determine the net worth of the bank and the equity to asset ratio;
In c)’s scenario, to maintain the equity to asset ratio at 40% which is required by the regulation, the bank decides to raise cash (zero duration and zero convexity) from the equity holders. How much cash does the bank need to raise?
Do you agree with the following statement? Explain why.

“The information about a bond’s duration and convexity adjustment is sufficient to quantify interest rate risk exposure.”

Thank You

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