1. A financial institution has the following market value balance sheet structure: (LG 19-1)
Assets Liabilities and Equity .
Cash $ 1,000 Certificate of deposit $ 10,000
Bond 10,000 Equity 1,000
Total assets $11,000 Total liabilities and equity $ 11,000.
a. The bond has a 10 year maturity, fixed–rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity at 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year? (Note: Net interest income minus interest expense.)
b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk of refinancing risk?
c. Assuming the market interest rates increase 1 percent, the bond will have a value of $9,446 at the end o year 1. What will be e value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends?
d. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why?