Financial Institution Balance Sheet Analysis and Interest Rate Risk Management

Use this balance sheet information to answer the following questions:

The bank has granted a special loan that has 3 years to maturity and has repayments of $357.875 million at the end of year 1, no payment at the end of year 2 and $357.875 payments at the end of year 3. The loan is trading at par and the yield to maturity is 5 percent per annum.

Assuming a flat yield curve and a parallel shift of the entire yield curve of 50-basis points upward what is the impact on the FI’s market value of equity? 

Calculate the convexity for a three-year 5% coupon rate with a face value of $500,000 loan. What is the convexity of the same loan but with amortised payments? 

Use this information to determine the impact on the market value of the bond loan and the amortised loan if the entire yield curve shifted downward 50-basis points. 

What is the usefulness of convexity when duration is available as a measure of interest rate risk? What is the practical implication for the three-year loan in this example?

In corporate finance the leverage ratio can be calculated by dividing capital by book value of assets. How have regulators altered this ratio to determine the capital adequacy requirements for banks or authorized depositor institutions? Compare Gorajek and Turner (2010)[ The article by Gorajek and Turner (2010) is located at the end of the homework.] analyses to those presented in Lange et al. (2015), Chapter 18. In your discussion consider the tension between the bank and the regulators.

For many years, Australian Express Company offered a charge card, called the Australian Express Card, which required its holders to pay off, in full, their card charges at the end of each monthly billing period.  In other words, cardholders could not maintain outstanding unpaid balances like VISA bank credit cardholders could.  Recently, however, Australian Express introduced a second card called the Optima Card, which was more like VISA credit cards in that Optima cardholders did not have to pay off all their unpaid balances. The interest rate charged by Australian Express was similar to other credit cards around 18%.

Assume that Australian Express Company cannot perfectly identify the credit risk of applicants for its two cards but takes equal care in checking card applicants for both cards.  Would you expect the default rate on the Optima Card to be lower, equal to or higher than the Australian Express Card? Explain.