Evaluating Bank Performance

Project description
Read the integrative problem below and respond to the following:

Identify the probability distribution of return on assets (ROA) for next year by completing this table:
Interest Rate Scenario
(Possible T-Bill Rate) Predicted ROA Probability
6%
7%
8%
Next year, will the bank?s ROA be lower or higher, if market interest rates decline? Support your decision. Note: You can use the T-bill rate to represent market interest rates.
INTEGRATIVE PROBLEM: As an analyst of a medium-sized commercial bank, you have been asked to forecast next year?s performance. In June, you were provided with information about the sources and uses of funds for the upcoming year. The bank?s sources of funds for the upcoming year are as follows (where NCDs are negotiable certificates of deposit):

Source of Funds Dollar Amount
(in millions) Interest Rate to be
Offered
Deman Deposits $5,000 0%
Time Deposits $2,000 6%
1-year NCD’s $3,000 T-Bill rate + 1%
5-year NCD’s $2,500 1-year NCD rate + 1%
The bank also has $1 billion in capital. The bank?s uses of funds for the upcoming year are as follows:

Use of Funds Dollar Amount
(in millions) Interest Rate Loan Loss
Percentage
Loans to small businesses $4,000 T-bill rate +6% 2%
Loans to large businesses $2,000 T-bill rate +4% 1%
Consumer loans $3,000 T-bill rate +7% 4%
Treasury bills $1,000 T-bill rate 0%
Treasury bonds $1,500 T-bill rate + 2% 0%
Corporate bonds $1,100 Treasury bond rate +2% 0%
The bank also has $900 million in fixed assets. The interest rates on loans to small and large businesses are tied to the T-bill rate and will change at the beginning of each new year. The forecasted Treasury bond rate is tied to the future T-bill rate because an upward-sloping yield curve is expected at the beginning of next year. The corporate bond rate is tied to the Treasury bond rate, allowing for a risk premium of 2%. Consumer loans will be provided at the beginning of next year, and interest rates will be fixed over the lifetime of the loan. The remaining time to maturity on all assets except T-bills exceeds three years. As the one-year T-bills mature, the funds are to be reinvested in new one-year T-bills (all T-bills are to be purchased at the beginning of the year). The bank?s loan loss percentage reflects the percentage of bad loans. Assume that no interest will be received on these loans. In addition, assume that this percentage of loans will be accounted for as loan loss reserves (i.e., assume that they should be subtracted when determining before-tax income). The bank has forecast its noninterest revenues to be $200 million and its noninterest expenses to be $740 million. A tax rate of 34% can be applied to the before-tax income in order to estimate after-tax income.

The bank has developed the following probability distribution for the one-year T-bill rate at the beginning of next year:

Possible T-Bill Rate Probability
6% 20%
7% 60%
8% 20%

Compose your work using a word processor (or other software as appropriate)

Finance and Accounting
Project description
Company A wants to borrow £25m for three years and is offered a variable rate loan commencing on 1st April 2014 at an interest rate of LIBOR + 3%, with interest re-set every six months. The company is particularly risk averse and would prefer a fixed rate loan and has a return requirement is 9% per annum.

Company B believes that interest rates are likely to remain stable over the period and is happy to pay floating rate interest in exchange for receiving fixed rate payments.

Assume that Company A and Company B arrange a derivative to be transacted on the 1st April 2014 so that Company A pays fixed interest over the period and Company B pays floating rate interest over the period. Assume that the fixed interest rate agreed for the it is LIBOR + 7% (fixed at inception), that LIBOR is 0.5% on 1st April 2014 and that on 30 June 2014 the LIBOR rate rises from 0.5% to 1%.

a) Describe the derivative trade that would enable such an exchange, the reasons why each company might want to transact such a derivative and calculate what the swap rate would be for Company A at inception. (choose a derivative)

b) How might Company B hedge its exposure to the interest rate rises and how might it fund that protection. You are required to show the impact of the strategy proposed using both a table and a graph.
c) What would the value of this derivative be on 02 September 2014 for Company A (using the Principal method)? Show how you reached your valuation using a cashflow analysis.
d) What risks are mitigated by this trade and what would you assess are the risks that this transaction represents for both Company A and Company B?

Finance and Accounting
Project description
Company A wants to borrow £25m for three years and is offered a variable rate loan commencing on 1st April 2014 at an interest rate of LIBOR + 3%, with interest re-set every six months. The company is particularly risk averse and would prefer a fixed rate loan and has a return requirement is 9% per annum.

Company B believes that interest rates are likely to remain stable over the period and is happy to pay floating rate interest in exchange for receiving fixed rate payments.

Assume that Company A and Company B arrange a derivative to be transacted on the 1st April 2014 so that Company A pays fixed interest over the period and Company B pays floating rate interest over the period. Assume that the fixed interest rate agreed for the it is LIBOR + 7% (fixed at inception), that LIBOR is 0.5% on 1st April 2014 and that on 30 June 2014 the LIBOR rate rises from 0.5% to 1%.

a) Describe the derivative trade that would enable such an exchange, the reasons why each company might want to transact such a derivative and calculate what the swap rate would be for Company A at inception. (choose a derivative)

b) How might Company B hedge its exposure to the interest rate rises and how might it fund that protection. You are required to show the impact of the strategy proposed using both a table and a graph.
c) What would the value of this derivative be on 02 September 2014 for Company A (using the Principal method)? Show how you reached your valuation using a cashflow analysis.
d) What risks are mitigated by this trade and what would you assess are the risks that this transaction represents for both Company A and Company B?