BE631 – Risk Management and Financial Institutions Seminar 1 Questions with analytical answers
BE631 – Risk Management and Financial Institutions
Seminar 1
堪培拉代写assignment,论文代写,留学作业代写peaking代写Questions with analytical answers
22^{nd}堪培拉代写assignment,论文代写,留学作业代写peaking代写 February 2021
Thanos Triantafyllou
Question 1
Suppose that as a fixed income trader for a bank you currently are holding the following fixed income portfolio of assets and liabilities:
Assets: $1 million face value, 6year coupon bond. 4.5% annual coupon payment, 3.5% yield to maturity.
$2 million face value, 2year zero coupon bond. 2% yield to maturity.
Liability: $3 million face value, 1year zero coupon bond. 1.75% yield to maturity.??

Assuming that when you set up these three positions, the total purchase price of the two assets was exactly equal to the funding generated by the issuance of your liability, determine the current amount of profits for this portfolio. This is its net worth.
Solution:
Asset side
堪培拉代写assignment,论文代写,留学作业代写peaking代写C = Coupon rate*face value = 1000000*0.045 = $45000
堪培拉代写assignment,论文代写,留学作业代写peaking代写Price of coupon bond = PV(coupon bond) = C/(1+ytm)+ C/(1+ytm)^2+ C/(1+ytm)^3+ C/(1+ytm)^4 +C/(1+ytm)^5+ (C+face value)/(1+ytm)^6 =
= 45000/(1.035)+ 45000/(1.035)^2+ 45000/(1.035)^3+ 45000/(1.035)^4 +45000/(1.035)^5+ (1045000)/(1.035)^6 = $1,053,286
?
Market Price of zerocoupon bond = PV(zero coupon bond) = face value/(1+ytm)^2 = 2000000/(1.02)^2=? $1,922,338
Market value of assets is therefore = market value (present value (PV) of coupon bond + market value (PV) of zero coupon bond = $1,053,286 +$1,922,338= $2,975,624
?
?
Liability side
Market value of liability = 3000000/(1+0.0175) = $2,948,403
?
Net worth = market value of equity = market value of assets – market value of liabilities= $2,975,624  $2,948,403 = $27,220
?
(Assets? = Equity + Liabilities? => Equity = Assets – Liabilities)
?
?
 Determine the total Macaulay durations of your assets and your liability. Comment on the discrepancy, specifically, what is the direction of interest rate changes that will lead to a reduction in this portfolio’s net worth?
?
Solution:
Asset side
Macaulay duration of coupon bond = [1*C/(1+ytm)+ 2*C/(1+ytm)^2+ 3*C/(1+ytm)^3+ 4*C/(1+ytm)^4 +5*C/(1+ytm)^5+6* (C+face value)/(1+ytm)^6 ] / Price of coupon bond =
=[1*45000/(1.035)+ 2*45000/(1.035)^2+ 3*45000/(1.035)^3+ 4*45000/(1.035)^4 +5*45000/(1.035)^5+6* (1045000)/(1.035)^6 ] /1,053,286 = 5.41 years
?
Macaulay duration of 2year maturity zero coupon bond = 2 years (the duration of the zero coupon bond is always equal to its maturity)
?
Weighted average Macaulay duration of assets =( duration of coupon bond*price of coupon bond + duration of zerocoupon bond*price of zerocoupon bond)/ market value of assets (the sum of bond prices belonging to assets) = (5.41 * 1053286 + 2 * 1922338)/2975624 = 3.21 years
(2975624 = 1053286+1922338)
?
Liability side
堪培拉代写assignment,论文代写,留学作业代写peaking代写Macaulay duration of liability = 1 year
?
So the portfolio will be hurt if interest rates rise, as assets have longer duration than the funding (liabilities). In the scenario of rising interest rates, assets (more interest rate sensitive) will fall more than liabilities (less rate sensitive). Hence the net worth (equal to assetsliabilities) will fall in value.
Question 2
We are currently in a global macro and political environment where there is widespread expectation that interest rates, starting from the USA, will rise significantly from their historic lows. Suppose that you are a member of the AssetLiability Management (ALM) committee at a US commercial bank and are concerned about the effect of rapidly rising interest rates on your bank’s profitability. ?堪培拉代写assignment,论文代写,留学作业代写peaking代写Discuss how each action listed below could be used to alter the interest rate sensitivity of your bank’s balance sheet and what they could mean for its interest margins.

a) Securitising a portion of the bank’s mortgage loan portfolio and investing the cash received in Treasury bills.
Solution: Securitising mortgages means bundling the loans into pools and selling them to investors. If the bank buys Tbills which by definition have shorter than one year maturities with the cash it received from the securitisation, then the net effect will be a lowering of asset duration in the bank’s balance sheet. So the bank will have less sensitivity to rates rising going forward.
The flip side is usually a decrease in interest income. Mortgage loans in general produce higher interest income than Tbills, so the bank would be giving that extra interest income up with this move.

b) Entering into payfixed, receive floating interest rate swaps with average maturity of 10 years.
Solution: this is equivalent to issuing a 10year bond and placing the proceeds into 3 or 6month LIBOR. So this action too will shorten asset duration, and it will at the same time lengthen liability duration. With an upward sloping yield curve, the receipts at least initially will be less than the payments on the swap, unless interest rates shift up considerably and fast. ?

c) Shorting Treasury bond futures.
?
Solution:
This will produce hedging income if medium to longterm interest rates rise. Recall that bond prices decrease if their yields rise and that the deliverable bonds in the various futures contracts that exist futures exchanges around the world usually have maturities that are in excess of 56 years. Margin payments will need to be made if rates go down, so the cash flow implications of that eventuality need to be taken into account. The yield curve may also twist in such a manner that while short term rates rise, thereby increasing funding costs for the bank, longer term rates that would apply to the deliverable bonds for the bond futures in question could stay the same or even fall. In that case the hedge would be grossly ineffective.
Question 3
Suppose that the one and twoyear zerocoupon bond rates are 2% and 2.2%, respectively. Determine the rate on the 12x24 forward rate agreement (FRA) (12x24 means settlement is a year from now for delivery of the 1year LIBOR at that date).
?
Solution:
From slide example: 1 + FRA_{12,24} = (1+z_{2})^{2} / (1+z_{1})
堪培拉代写assignment,论文代写,留学作业代写peaking代写Z1: the one year zero coupon interest rate
堪培拉代写assignment,论文代写,留学作业代写peaking代写Z2: the two year zero coupon interest rate
Under the law of noarbitrage, the two year investment must be equal to the 1year investment and the subsequent 1year forward rate investment.
1* (1+Z_{1})(1+FRA_{12,24}) = 1*(1+Z_{2})^{2} =>
1 + FRA_{12,24} = (1+z_{2})^{2} / (1+z_{1})
So 1+FRA = 1.022^{2}/1.02 ? FRA =? 堪培拉代写assignment,论文代写,留学作业代写peaking代写0.024 or 2.4%
?
Question 4
堪培拉代写assignment,论文代写,留学作业代写peaking代写For the FRA contract in Question 3, determine the settlement payment that the buyer has to make on $100 million notional principal if at the settlement date (which is one year from the date of purchase of the FRA) oneyear LIBOR turns out to be 1.9%
?Solution:
The buyer pays FRA and receives LIBOR. Since LIBOR is less than the FRA rate in this case, the buyer needs to make a payment. The payment amount is 100,000,000*(0.0240.019)/1.019 = $ 490,677. Note the present value adjustment in the payment calculation. This is necessary because the FRA is settled a year from now while the interest payments are due 2 years from now. See graph in lecture slides for timings.??