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Exercises. Federica Ielasi 2010 October 28. Exercise. Rank the following bank assets from most to least liquid: Commercial loans Securities Reserves Physical capital. Sol. Reserves Securities Commercial loans Physical capital. Exercise.
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Exercises Federica Ielasi 2010 October 28
Exercise • Rank the following bank assets from most to least liquid: • Commercial loans • Securities • Reserves • Physical capital
Sol • Reserves • Securities • Commercial loans • Physical capital
Exercise • If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans?
Sol • You should want to make short-term loans. • Then, when these loans mature, you will be able to make loans at higher interest rates, which will generate more income for the bank.
Exercise • If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE?
Sol • To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. • Alternatively, it can keep its capital constant but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities withthesenewfunds. • Northern Rock ROE at the end of 2006 = 23,5%!!
Exercise • One problem for investors in long-term coupon bonds, even when investors have a long holding period, is that there is some uncertainty in their returns arising from what is called reinvestment risk. Even if an investor holding a long-term coupon bond has a holding period of 10 years, the return on the bond is not certain: the coupon payments must be reinvested. • In contrast, long-term zero-coupon bonds have no reinvestment risk because they make no cash payments before the bond matures. The return on a zero-coupon bond if it is held to maturity is known at the time of purchase.
Exercise • The investors are willing to accept a slightly lower interest rate on zero-coupon bonds than on coupon bonds • Banks can separate (“strip”) a long-term coupon bond into a set of zero-coupon bonds • A $ 1,000,000 10-year Treasury bond might be stripped into ten $ 100,000 zero coupon bonds: Treasury strip zero-coupon bonds
Exercise • Coupon rate of Treasury bond = 10% • Yield to maturity = 10% • Interest rate on the zero-coupon bonds = 9.75%
Sol • The total present discounted value of zero-coupon bonds is $ 1,015,528… • … which is greater than the $ 1,000,000 purchase price of the Treasury bond.
Sol • ROE = 13,33% • Positive interest rate = 7,2% • Negative interest rate = 6,5% • Working capital = 500,000