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Exam I Review

Class 9 Chap 1-6, 8, 9 Introduction, Depository Institutions, Finance Companies, Insurance Companies Mutual funds, Interest rate risk, Duration, Convexity. Exam I Review. Disclaimer. You are responsible for all the material presented in class and in the book since the first day of class.

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Exam I Review

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  1. Class 9 Chap 1-6, 8, 9 Introduction, Depository Institutions, Finance Companies, Insurance Companies Mutual funds, Interest rate risk, Duration, Convexity Exam I Review

  2. Disclaimer You are responsible for all the material presented in class and in the book since the first day of class. This is a review of some elements of that information. This is not a comprehensive review of all the information you will be responsible for on the Exam!

  3. Exam I • Exam I will cover: • Chap 1-6, 8, 9 • From the first day of class up to hedging interest rate risk with duration gap

  4. Introduction • Main Role of FIs in the economy • They channel money from savers to borrowers by borrowing money (deposits-liabilities) and lending money (loans - assets) • We looked at a world with and without financial institution • Financial Institutions provide value by reducing: • Information Risk • Moral Hazard • Adverse Selection • Liquidity Risk • Price Risk • A few other reasons

  5. Depository Institutions • Types • Commercial Banks • Savings Banks and Savings & Loans • Credit Unions • Borrowing and Lending Activity • Assets – Mainly Loans (mostly mortgage loans) • Liabilities – Deposits – in different forms • Industry Composition: • S&L Crisis • Commercial bank merger wave

  6. Finance Companies • Types: • Sales Finance – provide credit to clients of parent Co. • Personal Finance – specialize in high risk installment loans • Business Credit – specialize in factoring • Borrowing and lending activities • Assets – consumer, business, and real estate loans • Liabilities – debt to parent, commercial paper, other loans • Advantages and disadvantages of different sources of financing

  7. Mutual Funds • Types • Open-end • Closed-end • Asset specialization • Short-term: money market mutual funds • Long-term: stock, bond, and commodity funds • Pricing • Net Asset Value (NAV) • Market price • Fee structure • Scandals

  8. Hedge Funds • We only briefly touched on hedge funds, so don't worry about this for the exam

  9. Insurance Companies • Types • Property Casualty • Life Insurance • Risk Exposure • Adverse selection • Moral hazard • High frequency low loss events • Low frequency high loss

  10. Investment Banks & Securities Firms • History/Industry composition • Different types of firms • Commercial Bank Holding Company; National Full Line Firms with corporate specialty; Large Investment banks; Regional Securities Firms; Special discount brokers; Special Electronic trading securities firms; Venture Capital Firms; Other Firms • Different Business Lines • Investing; Investment banking; Market Making; Trading; Cash Management; Mergers & Acquisitions; Bank office and other services; • Profitability through time • Fixed commissions • Underwriting • Regulation

  11. Calculation problems: • Underwriting – firm commitment & best efforts • Mutual fund share valuation • Repricing GAP – the change in NII • Bond Pricing • Duration • Convexity • Duration GAP

  12. Underwriting example Exxon oil decides to raise capital to develop a new oil well in the Gulf of Mexico by issuing $100M in non-callable 10-year notes. They higher JP Morgan to underwrite the issue. Calculate the total proceeds from the issue received by Exxon and JP Morgan's under the following agreements • JP Morgan sells 95% of the issue in a best efforts agreement with a target price of $734.00 per bond ($1,000 face value). JP Morgan charges an underwriting fee of $0.025 per dollar of face value. • JP Morgan sells 80% of the issue for $750.00 in a firm commitment agreement with target price of $720.00.

  13. Mutual Fund Share Valuation Primus funds manages a closed-end mutual fund. The fund holds 300 shares of Google priced at $132/share 2000 shares of Bank of America priced at $16/share , 1200 shares of Amazon priced at $36/share. • Calculate the net asset value of the fund if there are 3200 fund shares outstanding • If the price of Google decreases to $90/share and BoA increases to 20, how many shares would need to be issued/retired (in a secondary offering) to keep the fund’s NAV constant? • At what price can shares in the fund be purchased/sold?

  14. Repricing GAP • Estimates the difference between the value of assets maturing and the value of liabilities coming due over a particular horizon • Positive GAP = reinvestment risk • Negative GAP = refinancing risk • Can be used to estimate the change in net interest expense for assets and liabilities over a particular horizon

  15. Repricing GAP Use the balance sheet to calculate the expected change in net interest income for assets and liabilities at the one-year horizon. Assume that the rate on RSA increases by 3% and the rate on RSL increases by 1%

  16. Duration: • Measures the sensitivity of the asset’s price to changes in the interest rate (YTM) • With a bond you receive your value in increments over many different time periods 1,000 40 40 40 40 40 40 40 40 40 40 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

  17. Duration: • Measures the sensitivity of the asset’s price to changes in the interest rate (YTM) • With a bond you receive your value in increments over many different time periods • Duration asks on average when do you receive the full value of the bond. 1,000 On average you receive the value of your bond 4.72 year after purchase Time value at D years 40 40 40 40 40 40 40 40 40 40 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

  18. Convexity • Refers to the non-linear (curved) relationship between bond price and YTM Duration is also the slope of the tangent line at a certain point (YTM)

  19. Bond Pricing , Duration & Convexity Calculate the duration and convexity for a three-year bond with face value of $1,000, annual coupon of 15% and YTM of 12%. Use duration and convexity to estimate the change in bond price if the YTM increases to 13%

  20. Duration GAP • Used to measure the sensitivity of equity capital to changes in interest rates • Can also be used to hedge equity capital against movements in interest rates. • Immunize – routine hedge • Partial hedge – selective hedge

  21. Duration GAP Lantek bank hires you to evaluate its exposure to interest rate risk. That is, they would like to know by how much their equity capital ratio will change if interest rates decrease from 8% to 7.5%.The duration of the banks asset portfolio is 7 years and the duration of their liabilities is 2 years. Additionally, they hold 500M in total assets financed with 470M in liabilities. They would also like to know what duration of liabilities will make equity capital immune to changes in the interest rate.

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