Financial Institutions

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FINAL EXAM TAKE HOME

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RAM NARESH KAMMELA | FINANCIAL INSTITUTIONS| 4/12/2018

Answer for Question 1:

1. Interest from asset side can be classified as Interest Income, conversely expense from liability side can be classified as interest expense.  If a FIs have excess cash, they keep their cash in ST investments such as purchasing Bonds, Money market funds, it earns interest which can be recorded as Interest Income in Income statement. Conversely, if FIs in need of money they can issue CODs to meet ST working capital requirements, the interest paid by doing so is called Income expense.

Fixed coupon rate for Bond                      = 10%          

Fixed coupon rate for COD                      = 6%

Interest Income is $10,000*10%            = $ 1000        

 Interest Expense is $10,000*6%           = $600

           Net Interest Income                        = Interest Income –Interest Expense

                                                                        = $1000-$600

                                                                        = $400.

                                   The NII at the end of first year is $ 400.

b) Market interest rates has been increased by 1% or 100 basis points. It means the bond coupon is not changes but changes occurred only in

Fixed coupon rate for bonds                     = 10%          

Fixed coupon rate for COD                       = 7%

Interest Income is $10,000*10%             = $ 1000        

 Interest Expense is $10,000*7%             = $700

           Net Interest Income                         = Interest Income –Interest Expense

                                                                        = $1000-$700

                                                                  = $300.

                                     The NII for second year is $ 300.

• Refinancing risk is a type of interest rate risk in that the cost of refinancing can be more than the return earned on asset investments.
• Reinvestment risk is when the cash earned on the assets is reinvested at a lower interest rate

The change in NII is the result of refinancing risk. Refinancing risk occurs when the cost of rolling over the COD liability occurs which is the new increase 7% rate.  

Answer for Question 2:

An Off-Balance-Sheet (OBS) activity is a term for assets and liabilities that do not appear on the company’s balance sheet. Most of the banks usually collect many fee-related activities that became important for them due to the income and the value generated by them. They are important to financial institutions because of the income they generate for the banks. Some of the off-balance-sheet activities include issuing letters of credit and engaging in derivative transactions (futures, options swaps and forwards). By taking the OBS activities, banks hope to earn some additional income which could supplement their decreasing margins on traditional lending.

Benefits:

• In off balance sheet financing, a company obtains finance but that finance does not show up on its balance sheet.
• There is no double-entry bookkeeping for off-balance sheet transactions.
• When financing obligations are kept off balance sheet, the assets that they finance are also kept off balance sheet.
• Off balance sheet financing results in an understatement of both assets and liabilities
• Keeping finance off balance sheet enables a company to present a stronger financial health
• Off balance sheet financing changes the capital structure of the company. It has an impact on the key ratios that are used to judge the financial health of the company

Risk Associated with OBS Activities:

Liquidity and funding risk: Funding difficulties may arise when, in order to meet sudden or unusually large withdrawals of funds, a bank is forced to rely on less stable, purchased deposits for a greater than normal proportion of its funding requirements. This may strain the willingness of the market to supply funds at competitive rates and may (perhaps wrongly) convey a signal that the bank is facing serious problems

Interest rate risk: Banks conduct a wide variety of activities off the balance sheet which have an impact on their interest rate exposure. Swaps, options and forward rate agreements, may be entered into as a hedge against on-balance-sheet interest rate exposures, or as banks see arbitrage opportunities open up between cash and futures markets or between one futures market and another. Swaps in particular will often be provided as a product in their own right. Some transactions may be undertaken with the deliberate aim of increasing net interest rate exposures. Where a bank acts as a market-maker in these instruments, this may lead to an increase in interest rate as well as in credit exposure.

Foreign exchange risk: Most Banks will charge a Fee on each transaction, if the OBS activities have a significant impact on banks foreign exchange exposures in just the same way as they do on interest rate exposures. Forward transactions, swaps, options or futures can either reduce or increase exposure to exchange rate changes.

Answer for Question 3:

• Face Value is $ 100,000, 3% Coupon paid semi-annually with current yield of 4$ and Current Price is $91,824.28. Macaulay’s Duration D is given by the following equation:

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By Using the above equation we can derive the following values in the below tabular form:

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With the current price i.e. $91,824.28 is below the face value, the bond is issued at a discounted price and after the bond has been issued the interest rates has been decreased due to the value of bond CFs has increased the face value. Interest rates has negative relationship with bonds.