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MGT411 Assignment No 02 Solutoin & Discussion DUE DATE: 8TH JANUARY, 2013

Question No. 1:
a) You are a bank manager and given the responsibility to manage the liquidity risk being faced by the bank. The Balance Sheet of the bank is given below:
Table: Balance sheet of a bank holding no excess reserves
Assets (in Million)
Liabilities (in Million)
Reserves Rs.15 million
Deposits Rs.90 million Rs.100million
Loans Rs.95 million
Borrowed funds Rs.35 million
Securities Rs.35 million
Bank capital Rs.20 million
A customer demands Rs.5 million cash withdrawals from the bank; what changes in the above Balance Sheet will occur if you decide to manage the liquidity risk through:
1. Adjusting assets by:
a. Selling the securities
b. Reducing the loans
2. Adjusting liabilities by:
a. Borrowings
b. Attracting deposits
Note: You are required to prepare four different Balance Sheets for each of the above mentioned strategies. (10 marks)
b) Discuss why bankers prefer liability management over asset management in order to mitigate liquidity risk? (5 marks)
Question No. 2:
a) You, as a bank manager, are managing the bank’s assets and liabilities in such a way that interest rate the bank has to pay on its liabilities is 4% while interest rate the bank charges on its various assets is 6%. Suppose 30% of the bank’s assets fall into the category of interest-sensitive while others are not sensitive to the changes in interest rate. Similarly, half of the bank’s liabilities are interest-sensitive while rests of the half are not. What will be the impact on the profitability of the bank if the interest rate rises by 1% on all assets and liabilities of the bank? (10 marks)
b) What will be the impact of increase in interest rate on the profitability of the bank if the bank has more interest-sensitive liabilities than interest-sensitive assets? (5 marks)

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MGT 411 just idea solution

What is liquidity risk?

There are two kinds of liquidity: market liquidity, and funding liquidity.

A security has good market liquidity if it is “easy” to trade, that is, has a low bid-ask spread, small price impact, high resilience, easy search (in OTC markets).
A bank or investor has good funding liquidity if it has enough available funding from its own capital or from (collateralised) loans.
With these notions in mind, the meaning of liquidity risk is clear.

Market liquidity risk is the risk that the market liquidity worsens when you need to trade.
Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind.
For instance, a levered hedge fund may lose its access to borrowing from its bank and must sell its securities as a result. Or, from the bank's perspective, depositors may withdraw their funds, the bank may lose its ability to borrow from other banks, or raise funds via debt issues.

 

Liquidity risk is the risk that a business will have insufficient

funds to meet its financial commitments in a timely manner.

The two key elements of liquidity risk are short-term cash

flow risk and long-term funding risk. The long-term funding

risk includes the risk that loans may not be available when

the business requires them or that such funds will not be

available for the required term or at acceptable cost.

All businesses need to manage liquidity risk to ensure that

they remain solvent.

Question No. 01

You are a bank manager and given the responsibility to manage the liquidity risk being faced by the bank. The Balance Sheet of the bank is given below:

Table: Balance sheet of a bank holding no excess reserves

Assets (in Million)

Liabilities (in Million)

Reserves Rs.15 million

Deposits Rs.90 million Rs.100millio n

Loans Rs.95 million

Borrowed funds Rs.35 million

Securities Rs.35 million

Bank capital Rs.20 million

 

 

 

 

 A customer demands Rs.5 million cash withdrawals from the bank; what changes in the above Balance Sheet will occur if you decide to manage the liquidity risk through:

  1. 1.          Adjusting assets by:
  2. 2.          Selling the securities

Ans. Less 5 Million securities on asset side and withdraw 5 million deposits

b. Reducing the loans

 

Ans.  Reduce the loan by 5 Million on asset side

 

 

2. Adjusting liabilities by:

a. Borrowings

Ans. Add borrowed Funds by 5 Million and withdraw 5 million deposit

  1. 1.          Attracting deposits

Ans. The same balance sheet which is given in question

 

Note: You are required to prepare four different Balance Sheets for each of the above mentioned strategies. (10 marks)

 

 

Interest Rate Risk'
The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).

The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.

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MGT 411 Assignment 2 Solution 2013

Answer 2 
A) The impact of an interest rate increase on bank profit (per 100 of assets)

Items Assets Liabilities
Interest rate sensitive 30 50
Not interest rate sensitive 70 50
Initial interest rate 6% 4%
Revenue from assets Cost of liabilities
At initial interest rate (0.06*30)+(0.06*70)=6 (0.04*50)+(0.04*50)=4

Assignment 2 Solution 
Table: Balance Sheet of a bank holding no excessive reserves
Assets Liabilities
Reserves Rs.15 Deposits Rs.90
Loans Rs.95 Borrowed funds Rs.35
Securities Rs.35 Bank Capital Rs.20
A Customers demands RS.5 million cash withdrawal from the bank 
1-Adjusting Assets
Table: Balance Sheet of a bank holding no excessive reserves
A)Withdrawal is met by Selling the securities
Assets Liabilities
Reserves Rs.15 Deposits Rs.85
Loans Rs.95 Borrowed funds Rs.35
Securities Rs.30 Bank Capital Rs.20
Table: Balance Sheet of a bank holding no excessive reserves
B)Withdrawal is met by reducing the loan
Assets Liabilities
Reserves Rs.15 Deposits Rs.85
Loans Rs.90 Borrowed funds Rs.35
Securities Rs.35 Bank Capital Rs.20



2-Adjusting liabilities
Table: Balance Sheet of a bank holding no excessive reserves
A)Withdrawal is met by borrowing
Assets Liabilities
Reserves Rs.15 Deposits Rs.85
Loans Rs.95 Borrowed funds Rs.40
Securities Rs.35 Bank Capital Rs.20
Table: Balance Sheet of a bank holding no excessive reserves
B)Withdrawal is met by attracting deposits
Assets Liabilities
Reserves Rs.15 Deposits Rs.90
Loans Rs.95 Borrowed funds Rs.35
Securities Rs.35 Bank Capital Rs.20

A customer demands Rs.5 million cash withdrawals from the bank; what changes in the above Balance Sheet will occur if you decide to manage the liquidity risk through:

  1. 1.         Adjusting assets by:

Increase the selling securities to 30 million and loan to 100 million  

 

  1. 2.         Adjusting liabilities by:

Browed 35 million increase to 40 million and loan increase 95 to 100 million.

Question#1 Solution:

Bond Valuation

 

Part a)

Bond value = c [1 – 1/(1+r)^n / r] + Par/(1+r)^n

Bond value = 90 [1 – 1/(1+0.10)^12 / 0.10 + 1000/(1+0.10)^12

Bond Value = 90 [1 – 0.3186 /0.10] + 1000/3.1384

Bond value = 90 (6.814) + 318.63

Bond value = 613.26 +318.63

Bond Value = 931

 

Part b)

Bond value = c [1 – 1/(1+r)^n / r] + Par/(1+r)^n

Bond value = 45 [1 – 1/(1+0.05)^24 / 0.05 + 1000/(1+0.05)^24

Bond Value = 45 [1 – 0.3100 /0.05] + 1000/3.2250

Bond value = 45 (13.8) + 310.07

Bond value = 621 +310.

Bond Value = 931

 

Part a)

P = Div(1+g)/rF +rP – g

 

D = 1.80

Rce = rF +rP = 12% \

g = 5%

 

P = 1.80 (1+0.05) / 12% - 5%

P = 1.80 (1.05) / 7%

P = 1.89/0.07

P = 27

 

Part b)

Div1= Do(1+g)3

Div1= 1.80 (1+0.05)3

Div1= 1.80 (1.1576)

Div1 = 2.083

 

P0 = D0 x (1 + g)/(R – g)

P0= 2.083 x 1.04/(0.12 – 0.04)

P0= 2.166 / 0.08

P0= 27.075

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